Italian Private Equity, In The Middle Of Change

Paolo Guida, University of Chicago Graduate School of Business

A thank you and appreciation note is due to investor managers and partners of those private equityfirms (listed in alphabetic order) who kindly devoted part of their precious time for interviews, making this research more reliable and accurate: Aksia Group, Argos Soditic Italia, Bank of America Capital Advisors, BS Investimenti SGR, Centrobanca, Industria e Finanza SGR, Investitori Associati, Private Equity Partners SGR, Quadrivio SGR, The Carlyle Group.

Special thanks also to AIFI and its Research Director for the useful hints that helped to identify important trends in the industry both at Italian and European level and to Mario Alvarez, from Chicago GSB, for the valuable advise he was able to provide.

By Paolo Guida

Executive summary

The Italian private equity sector has structurally grown in the past ten-fifteen years and todays can be considered an industry with approximately one hundred active investment firms that try to differentiate by targeting specific vertical markets (i.e. fashion), economic situations (i.e. turnaround) and company size ("mega-deals" versus middle market). Total amount invested tends to swing hugely from year to year depending on the number and value of LBO transactions. Despite this fact, Italy currently represents the 4th largest European market, with a core of 1.5-2.0 billion euro value, characterized by peaks of about 3.0 billions. In terms of weight on the overall economy, the Italian private equity sector is aligned to the European average (approximately 0.30% of GDP).

Lack of early stage high-tech venture funding, but richness of SMEs, leaders in their market niche, seem to have pushed domestic investors to find an "Italian way" to private equity. During the last few years in fact, Italian investors regularly ranked second in Europe just behind their British colleagues in terms of average deal size. This has created the Italian effect of the "mini-LBOs", which applies a financing technique traditionally used in multimillion euro transactions to acquire cash-flow generating companies in the middle market. As showed by official data, the typical deal is a buyout transaction, with family changeover problems resolved with the equity entrance of an institutional investor. The ideal target is generally represented by a middle market firm located in the north of Italy, leader in a stable niche manufacturing market, with sales of about 30-60 million euro and 15% profitability margin. The importance of corporate family changeovers is further confirmed by a recent research performed by University of Nottingham that shows how in Italy the percentage of firms facing these challenges is higher than in other European countries.

Despite various success stories, the relationship between entrepreneurs and private equity investors is not always easy. Family owned businesses remain culturally unprepared to accept new external shareholders because they tend to strongly identify with the company that either they or their parents successfully launched. They also remain convinced that the firm is destined to prosper or to perish with them, hardly accepting any clear separation of property and managerial control. This can be seen both as a problem of communication and as a problem of trust. With respect to the first aspect, investors should devote more efforts to explain to entrepreneurs how they can be better off, thanks to the support of private equity firms, that can bring new financial resources, increase the capability to attract new managerial talent, while improving internal corporate governance rules and making possible additional growth through the access to new markets. In terms of mutual trust, it is worth noticing how, within the Italian culture, individualism and skepticism tend to prevail. It's not a case that Francis Fukujama in his book "Trust based society", studied Italy as an example of a not-trusted economy, where people tend to trust only their closest family relatives, while keeping others at due distance. The same analogy applies to relationships between private equity investors and entrepreneurs. A well known motto in the industry holds that "the best friend of a private equity investor is a good lawyer, followed than by a very diligent accountant (who takes care of the due diligence process). This view is supported also by Scott Meadow, clinical professor of entrepreneurship at Chicago GSB, who points out how "the first thing a private equity investor must do is to protect himself from the downside risk, since upside will take care by itself".

Unfortunately, difficulties are not related just to the lively relationship between entrepreneurs and private equity investors. Many facts have dramatically changed the economic scenario during the past five years, imposing strategic choices different from the past. Since Italy joined EU and the single currency system, the weapon of devaluation as a support for export-driven production has disappeared. In the unified European market, size is important in order to ensure the critical mass needed to invest in R&D and product development. Italian firms are usually too small to compete effectively and many entrepreneurs still resist the idea of being part of an aggregation process that may lead to reduced corporate control. High prices of oil and raw material, combined with increased competition from Far East countries in sectors where the Italian economy was traditionally strong, have caused new troubles for many Italian firms. Because of their limited dimension, Italian companies are often unable to get control of domestic distribution channels and to profit of the great opportunity, represented by India and China integrating in the world economy. As Darwin noticed, "it's not the strongest who survive, but the one who is most adaptive to change", entailing that Italian firms will be forced to find new ways to compete and prosper. In order to support these efforts, some Italian private equity investors have opened offices in China and recruited local partners to help portfolio companies to build a long term presence in those markets by investing in production facilities and distribution channels.

Other processes are taking place inside the private equity industry. Lower cost of capital and increased liquidity tend to drive the whole sector towards a higher level of maturity, with more standardized business practices and commoditization of some traditional skills. As a consequence, the secret of successful investors today tends to be closely related more to core capabilities of individuals (and teams) than to specific technical abilities. In a highly complex and fast changing business world, neither knowing how to create a complex financing structure nor owing some distinguishing knowledge is an advantage per se. By quoting one of the founding partners of KKR, which has some common shareholders with respect to his own fund, Mr Sattin says "the capability to select the right management and to structure the most proper incentive mechanisms are the two most important skills a private equity investor must have".

Choosing the best management is a challenge that has to do both with industry knowledge, strong track record in delivering top notch results and showing the right attitude towards risks. In other words, managers must feel confident to be able to do the job, while living with the uncertainty of possible replacement in case results are not achieved. On the other side, high risks tend to be compensated with high rewards. Totally convergent incentive systems are strong motivational means that ensure alignment of investors' and management interest while creating virtuous decision making mechanics. Leading investors define schemes where management remuneration is a function of company's economic performance (management by objectives or MBO, often with unlimited cap) and deal returns achieved by equity shareholders (IRR driven mechanism). Managers are normally required to commit a part of their personal wealth by co-investing, while equity stock options tend to be used as (cheaper but) effective tool for motivating middle management. A recent research ("Why private equity do it better"), developed by Insead faculty on a dataset of Italian LBO transactions, clearly shows that effective incentive mechanism is one of the most powerful tools for value creation in LBO deals.

Other key characteristics of successful private equity executives are related to the major traits of their personality. Firstly, they possess strong business acumen and entrepreneurial push, being ready to take fast decisions when needed, but also prepared to withdraw when the deal is too risky or expensive. Secondly, they have developed strong networking capabilities, which are extremely important for securing access to deal flow of proprietary transactions. Successful private equity investors are always on the road to build long term relationships with many players such as industry experts, investment banks, lawyers, accountants, managers and management consulting firms. Finally, strong social and interpersonal skills must be successfully applied not only in the external world, but inside the invested company. The amount of time spent discussing corporate strategy and business plan with management before the transaction is closed, and later on to making sure the agreed action plan is implemented is a crucial value driver. All in all, it is clear that being a successful private equity manager requires a lot of technical and soft abilities, but for those who succeed, satisfaction can be great not only because they have created new wealth, but also because they contributed to transforming potentially good companies in performing market leaders.

The big picture: key industry trends and metrics

The Italian private equity market has grown steadily during recent years. This trend is witnessed both by an increase in the number of operators and by the amount of funds invested. Since 1986, the year in which AIFI, the Italian Private Equity and Venture Capital Association was constituted, it is possible to identify three main phases:

- From '86 to 96' pioneering private equity firms were established. Their number remained stable around 25-30 for approximately ten years.

- From '97 to '01 booming capital markets and spread out of new technology ventures generated interest in riskier asset classes and attracted more operators. The number of AIFI official members peaked at 86 in 2001, nearly tripling in less than five years.

- As the markets crashed, at the beginning of the new century, investors became more risk adverse: some firms stopped their investments; others gave back fund's resources to their shareholders, going out of business. On the other hand, new initiatives were launched, especially in the buyout segment, maintaining the number of AIFI members stable around 80 for the past three years.

Structural growth of Italian the private equity and venture capital industry is evident also in terms of amount of money invested and number of deals closed. While in 1998, operators invested a total of 944 million in 269 deals, in 2000 646 transactions where closed, for an equity value close to 3 billion euro. It's worthwhile to notice the huge impact that so called "mega-deals" (defined by AIFI as equity investments equal to or higher than 150 euro million). During each one of the past seven years an average of two to four of such leveraged buyout (LBO) transactions occurred. These deals caused great swings and volatility in the total value of the market. While representing on average 25% of the amount invested, "mega-deals" in 2003 brought private equity activity to its peak, even surpassing data for 2000 (the four largest transactions represented 57% of total investments). At the opposite, in 2004 only two transactions exceeding 150 million euro were closed (some are expected to be finalized in 2005) and the market showed a contraction to 1.5 billion euro. Excluding the impact of "mega-deals" and the effect of the internet bubble, Italy seems to have reached stability in the range of 300-400 deals a year, for an equity value of approximately 1.5-2.0 billion euro.

One way to assess the growth potential of the private equity and venture capital industry within a specific country, compared to other European nations, is to express the value of investments as a percentage of gross domestic product (GDP). When doing so, the European and Venture Capital Association (EVCA) uses total investments by country of origin rather than investments by country of destination to compute the numerator. According to this practice, UK represented in 2003 46.5% of total European investments, or 0.85% of GDP. Other countries such as France and Italy accounted for 14.6% and 10.4% of total European investments, with a percentage of GDP of 0.27% and 0.23% respectively (against a European average of 0.29%).

A more correct way of computing these statistics should consider the potential of a specific private equity market not for the amount of resources under management, but for the value of investment that an economy is able to trigger. When using country of destination statistics, UK leadership remains undisputed (26.7% share and 0.46% of GDP) but the gap with other European countries is less pronounced. France for example would account now for 17.6% of total market, but for 0.31% of GDP, while Italy could be, with Germany, the third most important market with a 14.5% share and 0.31% of GDP, just above the European average. Other countries like Ireland, Sweden and Finland, despite their relative small dimension, would jump ahead of the ranking in terms of capability to attract venture capital and private equity investments (0.41 to 0.36% of GDP). Despite that the 2004 EVCA data have not been officially released, it is worth to noticing that Italian performance in 2003 was heavily affected by some large transactions that where not repeated in 2004. By recalculating the impact of private equity and venture capital investments on GDP by assuming the "normalized" 1.5-2.0 billion threshold, the same statistics would have led to 0.12- 0.15% penetration rate, well below the European average. These numbers seem to indicate that there is room for additional growth for the Italian private equity industry in the next years.

An important comment must be made with respect to the distribution of investments. While

European countries dedicate on average 7.4% of total resources to seed and start-up financing, with a peak of Sweden and Germany (16.9% and 11.8%), launching new ventures in Italy seems more difficult and risky. With only 1.9% of investments conveyed in new entrepreneurial initiatives but 74.4% of total funds committed to buyout transactions, Italy represents an attractive market for more "financial" players, but poses serious questions concerning its competitive position and innovation capabilities in the long-run.

In terms of returns, Italy confirms to be an attractive market. AIFI and KPMG estimate that, despite gross IRRs decreased over time (from 34-35% of '01-'02 down to 17.8-24.7% in '03-'04) due to stiffer competition and higher liquidity, net returns remain attractive (13.4%) compared to US and EU average (12.5 and 9.8%).

The supply side: investors and competitive environment

AIFI members are highly representative, but do not compose the entire private equity and venture capital community. There were 97 operators active on the Italian market as of 2004. Out of those almost 50% was constituted by Italian closed-end funds. Banks play a central role not only because formally acting as direct investor in 13.4% of cases, but also because representing 50% of all Italian closed-end funds structured in form of "Società di Gestione del Risparmio" or SGR. Pan-European buyout funds accounted for 19.6% of the total, while regional / public operators play a marginal and negligible economic role.

By analyzing the contribution of private equity operators, few persistently rank as successful deal makers, while the vast majority executes none or few transactions in a given year. In the early stage segment for example, the top 3 operators account for 66.9% of the total investments, while in the buyout arena the top 5 players represent 71.8% of the market by value. The expansion segment remains the most fragmented and competitive market.

A recent research ("Private Equity Monitor 2004") described the general traits of a typical deal in the Italian private equity market. Buyout transactions, with family changeover problems resolved with the equity entrance of an institutional investor are the most common type of transaction. Private equity investors normally acquire the majority of voting rights and the control of the company, structuring a deal with the existing management or bringing in new executives with the goal to exit the investment in a 3-5 year period.

The ideal target is generally represented by a middle market firm located in the north of Italy, operating in a stable niche manufacturing market, where it has developed a long term sustainable competitive advantage (for example in terms of proprietary technologies) and generating 30-60 million euro in sales with an EBITDA (Earning Before Interests, Taxes, Depreciation and Amortization) margin of approximately 15%.

As more and more operators focus on the SME ("Small and Medium Enterprise") segment, which is thought to represent the real skeleton of Italian economy, competition tends to become very intense while other market niches remain completely unexploited. Recent statistics presented by AIFI, clearly show that long term growth perspectives for the private equity industry are tightly correlated to the number and diversified profile of operators. According to both these metrics, UK is by far the most mature European market, followed by France and Germany. Despite a smaller economy (57% of GDP in 2003), Spain shows higher momentum than Italy, both in terms of number of operators and number of investments. This fact is explained by a more spread out structure on the supply side, where regional public operators cooperate with private investors with the common objective of sustaining new ventures both at local level and in the high-tech space. Recent discussion in the Italian policy making area finally seems to indicate that the bottleneck to industry growth has been identified and that concrete actions for reducing the gap may soon be taken.

Constrained by the shortage of skills and critical mass needed to deal with high-tech venture investments, Italian private equity operators try to react in two ways: first of all by implementing a more "efficient" capital allocation. The amount invested per operator has been second only to UK on a European scale during the past three years. Furthermore efforts to differentiate through specialization are becoming more and more evident. New funds have recently targeted specific vertical sectors (fashion and mechanic industries), geographic coverage (North-East of Italy) or economic vocation (new turnaround initiatives have been announced, even if existing legislation remains a serious hurdle to growth).

Being a successful investor is becoming harder and harder. This fact is true not only because of an increased competition brought by high liquidity available for investments in alternative asset classes, but also because of peculiarities of the Italian economy. Family owned businesses, an important part of the production system, remain culturally unprepared to benefit from the opportunity represented by access to institutional investors.

Entrepreneurs continue to strongly identify with the company that either they or their parents successfully launched. They also remain convinced that the firm is destined to prosper or to perish with them, hardly accepting any clear separation of shareholder property and managerial control. Additionally it looks as if there is a communication problem. The inspiring logic of the discussion between entrepreneurs and investors is not always driven by shareholder value creation. Efforts should be made to prove how entrepreneurs, who are ready to open their firm to private equity investors, see their companies to grow more rapidly and perform better than their peers. These results are explained by stronger financial backing, capability to attract new managerial talent (even to replace underperforming managers), better corporate governance rules and possibility to access new markets.

Unfortunately, difficulties are not related just to the lively relationship between entrepreneurs and private equity investors. Many facts have dramatically changed the economic scenario during the past five years, imposing strategic choices different from the past. Since Italy joined EU and the single currency system, the weapon of devaluation as a support for export driven production has disappeared. In the unified European market, size is increasingly important in order to ensure the critical mass needed to invest in R&D and product development. With globalization many Italian firms suffer foreign competition because of the reduced scale of their operations. Unfortunately, many entrepreneurs still resist the idea of accepting to be part of an aggregation process that may lead to reduced corporate control.

High prices of oil and raw material, combined with increased competition from Far East countries in sectors where Italian economy was traditionally strong, such as textile and apparels, have caused another shock to many Italian firms (especially hitting those positioned in the medium and lower market segments). Cut-throat competition on prices and difficulties in accessing raw material sources are a serious threat for many firms. On the other side, India and China integrating in the world economy represent a great opportunity that can be grasped only by creating local production facilities and distribution networks. In both cases corporate size is the critical variable and Italian firms once again are at disadvantage compared to their European and international competitors.

The Darwinian selection activated by these fundamental economic processes is simply destined to further accelerate in the future and Italian firms risk to loose further ground. Private equity investors may represent an important resource for attracting those financial resources and managerial talent needed to react. Unfortunately, institutional investors are not benefactors, but business driven professionals, that prefer to invest in performing firms. As a result, few winners will be able to find the push to emerge, naturally acting as consolidators in a shrinking supply side of the economy.

Human touch: which skills are needed to succeed.

In an increasingly competitive environment standing out of the crowd becomes more and more difficult. One of the goals of the article is to identify the relevant skills and background (if any exist) needed to succeed in the private equity and venture capital industry, both at firm and investment manager level. An extensive analysis was performed to match academic papers and industry reports with data collected through one to one interviews with executives in the Italian private equity and venture capital community.

While it is hard to identify a prevailing profile and background for the typical investment manager, it can be helpful to structure the analysis with respect to the position taken by the private equity firm in the investment life cycle. By identifying successful firms in each group it is then possible to identify the relevant skills developed by their best performing individuals.

Early stage investors typically focus on high risk / high return investments (the demanded IRR is normally around 50%). Since each single investment carries high risks, venture capitalists tend to build a diversified portfolio, investing on average in twenty to thirty companies. US experience shows that out of those, 40% of invested companies fail, 40% perform in line with the industry average, while the few remainders become strong candidates for transforming in future industry leaders, ensuring extraordinary returns to their shareholders.

From a technical standpoint, in early stage venturing, industry knowledge (in terms of existing technologies and products, customer needs, marketing requirements and business practices) is key in order to be able to see the big pictures and understand how a new business idea can fully develop its potential by:

- creating a disruption in the current competitive environment thanks to a sustainable competitive advantage, based either on proprietary technologies or on a unique market positioning

- setting up the "dream team", composed by the best people and mix in terms of leadership skills, product development capabilities and ability to develop sales

- maintaining a long term perspective (typically with an holding period spanning from seven to ten years), while monitoring day to day progresses in the implementation of firms' strategic roadmap.

At the opposite side of the spectrum, LBO/replacement specialists invest in well established companies, typically leaders in niche or slow growing markets where capital investments are constrained to a level needed for maintaining existing site capabilities. Due to high and stable cashflows, investors tend to accept lower returns (normally in the order of 25%), with an holding period of about three to five years. Typical LBO funds are European or global investors with committed capital often exceeding 1 billion euro that normally invest up to 10% of the available resources in every single deal, generally resulting in portfolios of seven to twelve companies.

In LBO firms, financial engineering capabilities and transaction experience tend to be more relevant, if not mandatory. Investment managers are required to have negotiation capabilities, to be able to close a deal effectively, while designing and securing complex multilevel financing structures, with different degrees of debt seniority and types of securities. Good understanding of accounting principles and practices are absolutely a must.

By jointly considering these skill sets, it is easier to see why investment managers working in early stage and LBO private equity firms tend to have different backgrounds. Prior to joining a venture capital firm, successful investment managers normally acquired sound industry knowledge working in business development positions in established companies, advising clients in strategy consulting firms within specific sectors or assuming operational responsibilities in portfolio companies. Investment executives in LBO firms instead, acquired M&A experience in investment banking institutions, ideally after having spent a couple of years in an accounting firm. Sometimes, and this is more frequent at senior level positions, private equity executives join LBO houses after a successful track record as managers of either highly respected international corporations or top performing invested companies.

Despite these big differences, successful investment managers in the early stage venturing and LBO firms share some common characteristics, which are more related to the soft-side of their personality and attitude. Private equity professionals have to prove to their shareholders that they are able to obtain strong returns. In order to do so, investors must possess business acumen and entrepreneurial push. When evaluating an attractive deal opportunity, the investment manager has to make a decision whether to invest or not. Taking risks is part of the game and mistakes may occur. Nevertheless, repeated judgment errors may compromise manager's reputation and track record, eventually resulting in adverse actions from existing and new potential investors. At the opposite, fear of investing may cause paralysis in decision making, and put investment managers in the awkward position of being forced to invest. Such a situation is highly dangerous because it can lead to irrational decisions, accepting deals that will never be able to meet the expected return.

Business acumen is not the only relevant skill which is needed to succeed. Successful investors are always on the road seeking new investment opportunities. While they are very selective in deciding how to invest, one of their golden rules is to try to avoid competitive auctions that tend to push up deal prices and depress returns. Networking capabilities are extremely important to secure a flow of proprietary deals, so that successful investment managers tend to build long term relationships with many players such as investment banks, lawyers, accountants, managers and management consulting firms.

Strong social and interpersonal skills are relevant not only towards the external world, but also with respect to the invested or target companies. It is important to be able to select the right managers and senior resources to run the company, while establishing with them sound and trusted relationships from day one. A recent study performed by McKinsey clearly shows a positive correlation between deal returns and the amount of time spent by in discussing corporate strategy and business plan with management before the transaction is closed. Even more important, investment managers must devote time and attention to implementing the agreed action plan immediately after closing. Once momentum is created it must exploited in the most effective way.

Alignment of investors' and management interest and decision making mechanics is key for the success of the deal. Incentive systems must be totally convergent. A common practice is to define schemes where management remuneration is a function of company's economic performance (management by objectives or MBO) and deal returns achieved by equity shareholders (IRR driven). Normally top managers are required to commit a part of their personal wealth by coinvesting so to create tighter linkage. Equity stock options are less popular than few years ago and tend to be used especially for motivating middle management.

Spasmodic focus on bottom line performance and clear understanding of value creation drivers in the target business sectors, creativity (shaping not obvious transactions), capability to cope with complexity (structuring difficult deals where the target company may be forced to grow through M&A) and independent judgment capabilities (not to overbid, always protect from the downside risk) seem to emerge as the skills that complete the profile of today's most successful investors.