On the Role of Private Equity for Entrepreneurial Growth: The Case of Italy
Francesco Baldi *
LUISS Guido Carli University
ABSTRACT
This article utilizes the unique information collected in four Surveys on Italian Manufacturing
Firms (SIMFs) spanning the 1995-2006 period to investigate the characteristics of those companies
that use internal equity as the only source of capital for financing their positive-NPV investments.
While capital structure decisions of (especially) large- and medium and small-sized firms have been
widely discussed in country studies, little is known about the use of the various forms of equity
capital in Italy. Empirical evidence suggests that firms that are more likely to make an exclusive
and pro-cyclical use of internal equity to finance their investments are mainly located in the
Northern and Central part of the country and tend to be steadily profitable but not export-oriented,
not innovative and R&D spenders. More interestingly, their prevailing family business model limits
the use of external equity (to avoid ownership dilution and loss of control) and debt (to minimize
bankruptcy costs), thus favoring the resort to internal equity. The resulting lack of resources for
innovation makes it impossible for them to grow and sustain a competitive advantage. This is an
economic disgrace as their total value added represents 0,75% of the Italian GDP in 2006. By going
beyond the mere assessment of the determinants of SMEs’ preference for internal (versus external)
equity conducted in prior studies, we argue that the active involvement of private equity (PE)
investors would bring most of these firms out of stagnation. We develop a framework that provides
guidelines on how their entrepreneurial model and associated value creation would be positively
impacted by PE’s non-financial support. Stronger policy efforts should thus be directed towards
promoting the growth of a PE market in Italy by removing the major regulatory and fiscal barriers
that still prevent it from having a positive, real impact on the real economy.
*
Francesco Baldi is an Adjunct Professor of Corporate Finance at the Department of Business and Management, LUISS
Guido Carli University, Viale Romania, 32, 00198 Rome (Italy). Email: fbaldi@luiss.it
1
1. Introduction
Firms’ capital structure decisions are a puzzle not yet fully resolved. The choice between
internal equity capital (retained earnings), external equity capital (e.g., private equity, VC, IPOs)
and debt for financing positive-NPV investment projects has been widely investigated from a large
firm’s perspective, thus focusing on survey data from listed companies and neglecting smaller firms
and their related databases.1 The key argument (also empirically supported) of capital structure
theory is that capital market imperfections play a significant role in affecting the way firms
financially support their value-creative projects. In this sense, optimal leverage may be explained by
a number of market imperfections including: corporate taxation (Modigliani-Miller proposition I,
1958) via formation of debt-related interest tax shields; agency costs of equity and debt due to the
monitoring activity performed by both new shareholders and debtholders against behaviors of
wealth expropriation and/or maximization of current owners (Jensen and Meckling, 1976);
transaction costs (e.g., bankruptcy or business disruption costs) (Altman, 1984; Leland, 1994);
information asymmetries, which may trigger signaling mechanisms between owners/managers
(insiders) and investors (outsiders) (Myers and Majluf, 1984).
The goal of our study – which uses the micro-level data from surveys on small-, mediumand large-sized firms operating in the Italian manufacturing sector conducted by Unicredit Group
over four distinct three-year-long periods (1995-1997; 1998-2000; 2001-2003; 2004-2006)
(spanning, in total, 12 years) – is threefold.2 First, we infer the characteristics of those companies
using internal equity as the only source of their capital when financing new investments. The
survey-based data we present here span the manufacturing sector in Italy, with 8,2% of the
responding firms having more than 250 employees (large firms), 27,7% between 51 and 250
employees (medium firms), and 64,2% less than 51 employees (small firms).3 Based on the above,
we classify Italian firms between users of equity capital only and users of a mixed capital structure
(equity and debt), with the former further divided into internal equity capital and external equity
capital users.4 Because only a small number of Italian companies in the sample make use of
1
This is mainly due to the tendency of treating financial issues of small and medium-sized firms as private information.
Unicredit is the leading bank group in Italy and one of the major banks operating in Europe.
3
As of the latest survey conducted in December 2008 and referred to the 2004-2006 period.
4
Internal equity capital users are those firms that retain earnings in order to finance their capital expenditures and
external equity capital users are those resorting to the informal channel of business angel investors, venture capital
2
2
external equity capital over the 12 years surveyed, our focus is on the behavior of internal equity
capital users contrasted with that of the rest of Italian firms choosing a mixed capital structure
(internal equity capital and external debt).5 Second, having highlighted the vicious circle that affects
the 3 Gs (Governance, Gearing, Growth) of the former, we elaborate on a portfolio of virtuous,
managerial actions that could derive from potentially raising external capital from private equity
(PE) investors and inheriting their value-oriented discipline. Third, we provide recommendations to
policymakers as to how to remove those barriers that still thwart the booming of the Italian PE
market.
Three sets of contributions emerge from our study and one important policy implication.
First, we underline the business model of those Italian manufacturing firms that finance their new
capital expenditures via internal equity, a relevant part of the country’s economy representing
0,75% of the 2006 Italian GDP in terms of total value added. In this sense, we contribute to the
large body of research attempting to explain capital structure decision-making in SMEs (Chaganti et
al., 1995; Chittenden et al., 1996; Berger and Udell, 1998; Romano et al., 2001; Ou and Haynes,
2006). Second, we explore the role that the corporate governance style associated with the
qualitative composition of the gearing ratio (who owns the equity, no matter how much debt has
been contracted) may play in fostering commitment, innovation and growth as an internal, virtuous
value creation process.6 In this sense, the surveys we use in this article serve as a unique source of
micro-level data, in general, on Italian manufacturing companies, and more specifically, on those
having a small and medium size, thus helping filling the gap between advanced empirical work
conducted in U.S. on the causal link between governance and capital structure models adopted by
small businesses and their growth potential and similar studies applying survey-based data to other
countries such as Italy (Petersen and Rajan, 1994; Cole and Wolken, 1995; Fluck et al., 1998;
(VC), private equity (PE) or public stock market via initial public offerings (IPO) when financially supporting their
positive-NPV projects. The order of priority in using such forms of equity financing depends on the specific phase of
the business life-cycle the company has entered: the earlier the stage of realization of the entrepreneurial idea, the more
likely the demand for capital from angels and VCs. More mature businesses would instead raise equity via PE investing
or IPOs.
5
In so doing, we confirm the empirical results from Fenn and Liang, (1998), who find out that in the U.S. market
companies obtaining external equity in the form of PE investments are a small proportion compared to the universe of
small and medium-sized firms, and growth is pursued via financing projects based upon earnings retention and bank
lending.
6
As far as a firm’s gearing ratio (debt-to-equity) is concerned, the focus here is on the quality of the denominator
(provided that the level of the numerator is financially bearable.
3
Gregory et al., 2005). What empirically emerges is that, because of a prevailing family-based
business model (the family owns the equity), Italian firms are reluctant to implementing a proactive,
value-oriented governance. The key policy implication is that a greater involvement of PE investors
in the boards of (especially) small- and medium-sized, mature Italian firms (due to the fact that PE
owns the equity) could dismantle the conservatism with which they are governed and strategized.
Here comes the third contribution of our study. While taking a part in the extant country
studies on the state of the PE industry around the world by providing insights into the Italian case
(Cumming and Johan, 2007; Cumming and Walz, 2010; Klonowski, 2011), more importantly we
contribute to the strand of PE literature on target company selection (Opler and Titman, 1993; Aslan
and Kumar, 2007; Bharath and Dittmar, 2007; Acharya et al., 2009). Our study differs from the
latter mainstream research in that rather than examining data from actual deals executed by private
equity funds or international aggregate industry-wide datasets, we instead focus on the empirical
evidence arising from firms that, because of their predominant characteristics indicated by literature
and driving decisions in professional practice, could potentially become investment targets of PE
houses but they have not accessed such a capital so far. More specifically, we go beyond the mere
assessment of the determinants of small and medium-sized firms’ preference for internal (versus
external) equity conducted in recent studies (Ou and Haynes, 2006) and argue that access to PE has
not yet happened for at least a fraction of them due to a lack of entrepreneurial culture for external
equity financing, on the demand side, and a number of market barriers, on the supply side. To the
extent that the active involvement of PE investors would bring most of these firms out of
stagnation, we develop a simple framework that in a normative fashion seeks to provide guidelines
on how their entrepreneurial model would be positively impacted by standard PE actions. The main
research questions we aim to address here can be summarized as follows: who are those firms
resorting to internal equity only to finance investments with positive NPV? What would be the
impact of external equity (PE) on their business operations in terms of what we can call the 3 Gs
(Governance, Gearing, Growth)? How can PE ownership expansion be expedited in Italy?
The article is organized as follows. Section 2 contains a review of the literature (and
associated cross-country empirical research) on the applicability of standard capital structure
theories to small- and medium-sized firms. Section 3 describes our empirical analysis (data
collection, econometric model and key findings). Section 4 discusses the role of PE ownership (as a
4
qualitative change to the equity component of a company’s gearing ratio, G) in improving corporate
governance (G) and resulting management practices of Italian internal equity capital users, thus
potentially stimulating the pace of their growth (G), and provides policy recommendations for
removing the major regulatory, legal and fiscal barriers that slow down the PE business in Italy.
Section 5 concludes.
2. Literature Review
Empirical research on the use of internal vs. external equity financing, especially in the
context of small- and medium-sized firms, is at a very early stage due to the lack of publicly
available data (e.g., surveys, etc.) and is mainly focused on the U.S. market.7 Small and mediumsized firms are indeed characterized by informational opacity for three key reasons (Schmid, 2001).
First, they are not required – as privately-held companies – to publish or disclose financial
information. Second, they lack publicly visible contracts with all of their stakeholders. Third, they
do not typically issue securities successively tradable on financial markets because the cost of
issuing public debt or equity is prohibitive for such firms. This amplifies the problem of
information asymmetries and explains why some of the major capital structure theories do not apply
to small- and medium-sized firms.
Modigliani and Miller (1956) argue that companies should select the mix of equity and debt
that both maximizes the value of the firm and minimizes its weighted average cost of capital
(WACC). However, the assumptions underlying their theorems on optimal capital structure
7
Past literature relies on four major surveys all produced in U.S.:
-
National Survey of Small Business Finance (NSSBF) (1993);
Wisconsin Entrepreneurial Climate Study (WECS) (1986-1991);
Federal Reserve Bank Call Report on small business lending (FRBCR);
Survey of Consumer Finances (SCF) (1995).
The NSSBF, co-sponsored by the Board of Governors and the U.S. Small Business Administration and at its second
edition, provides a representative sample of U.S. non-farm, for profit, non-financial small firms. Data from this survey
are used by Petersen and Rajan (1994), Berger and Udell (1995) and Ou and Haynes (2006). The WECS is a survey
produced by the Marquette University on active young firms and is used by Fluck et al. (1998). The Bank Call Report not properly a survey, but a Federal Reserve census - is an important dataset on the use of external debt in U.S. (with a
size limit of $1,000,000 for reported firms to which loans are granted). The SCF, conducted by the Board of Governors
on U.S. households, is particularly helpful for studying the relationship between business ownership and personal
assets.
5
(propositions I and III) do not evidently hold for small firms.8 Agency theory (Jensen and Meckling,
1976) is based on the central premise that “managers, as agents of shareholders (principals), can
engage in decision-making and behaviors that may be inconsistent with maximizing shareholder
wealth” (Daily, Dalton and Rajagopalan, 2003). Clearly, agency issues are of little or no
significance in the context of small- and medium-sized firms due to the prevailing, inherent
coincidence of interests between owners and managers.
Based on a sample of more than 900 small U.S. firms, Chaganti, DeCarolis, and Deeds
(1995) find out that both the signalling theory (Leland and Pyle, 1977; Ross, 1977) and the pecking
order theory (Myers and Majluf, 1984; Myers, 1984) are – on the contrary – relevant to small- and
medium-sized firms.9
10
In particular, Chaganti et al. show that managers who are confident about
the future prospects of their firms would prefer making use of internal equity rather than debt or
external equity capital in line with both theories. An additional empirical test for the extent to which
the pecking order theory suits small firms is provided by Chittenden et al. (1996), who find out that
(on the basis of a sample of over 3,000 small British companies) small profitable firms finance their
operations via earnings retention and those with lower profitability typically resort to short-term
(rather than long-term) debt.
Key to understanding the financing issues of small- and medium-sized firms is also the
paradigm of the financial growth cycle proposed by Berger and Udell (1998). These authors argue
that firms employ different types of funding across different stages of growth. In other words,
optimal capital structure varies with the age and size of companies. Because intermediated capital
of external nature cannot be easily raised by start-up firms which are not informationally transparent
8
Such assumptions are: the absence of transaction costs, the availability of the same information about the firm to both
managers and investors, the full access to debt and equity instruments.
9
Coleman and Cohn (2000) also argue that asymmetric information is such an inherent feature of small and privatelyheld enterprises that pecking order theory is particularly applicable in such a context.
10
Signaling theory argues that the owner’s willingness to (re)invest in his own business may serve as a signal about a
firm’s asset quality and earnings prospects. Pecking order theory suggests that managers (insiders) tend to issue new
shares only when the firm is overvalued (growth prospects are not good). However, such a recourse to public equity
reveals the above “internal” information to investors (outsiders), thus destroying the insiders’ informational advantage.
Such an information asymmetry problem is resolved if a priority order is followed in choosing the means of financing:
i) available liquid assets (formed via earnings retention) are first used to financially support positive-NPV projects; ii)
debt financing may be subsequently used in that it is less correlated with future business conditions; iii) external equity
is issued as a source of funding of last resort. Pecking order theory implies that the proportion of funds arising from
earnings retention increases with the rise of firm size and decreases with the erosion of its growth prospects. If (and
until when) the firm grows generating enough earnings, management will exploit this source of funding and resort to
external finance thereafter (Fluck et al., 1998).
6
and whose balance sheets are mostly intangibles-driven (not useful as collateral), they are forced to
rely on an “informal” type of finance (owner’s personal funds, business angels). Earnings retention
would follow due to the enduring informational opacity in the earlier phase of their lifecycle. Upon
termination of the start-up stage, owners aimed at propelling expansion and growth must turn to
external sources of financing showing preference for debt (rather than equity) so as to keep control
over the strategies and business operations of their firms. Only large firms that have reached a
maturity stage and are less risky (because they are less affected by business volatility) may issue
stocks and bonds on public markets. In this respect, Michaelas, Chittenden, and Poutziouris (1998)
demonstrate the empirical consistency of the financial growth cycle paradigm via conducting indepth interviews with a sample of thirty small U.S. companies.11
Notwithstanding, the effects of the financial growth cycle paradigm are mixed and several
additional firm-specific factors may also influence the choice between internal and/or external
equity and external debt, including – along with growth stage (Fluck et al., 1998; Berger and Udell,
1998) - industrial classification (Fenn and Liang, 1998; Timmons, 1997; Carpenter and Peterson,
2002); owning family’s goals (Barton and Mathews, 1989; Petty and Bygraves, 1993; Kuratko,
Hornsby and Nafizinger, 1997); risk preference (Bolton and Freixas, 2000), and government policy
(Papadimitroiu and Mourdoukoutas, 2002; Tucker and Lean, 2003).12 For instance, high-growth,
technology-driven firms have a substantially higher probability of accessing external equity
compared to other firms. This is due to the fact that, while these types of companies may offer angel
and venture capitalists the expectation of high returns, they are also characterized by highly variable
11
Michaelas et al. (1998) find out that small U.S. companies prefer not to raise external equity in order not to dilute
control, thereby considering earnings retention as the most important source of financing followed by bank-originated
debt. High-growth firms entering their expansion stage are instead more likely to employ external capital, as they may
have exhausted their internal equity sourcing. Two further studies that rely on data from the NSSBF provide support for
Berger and Udell (1998)’s theory of financial growth cycle. Cole and Wolken (1995) draw data on about 4,000 U.S.
firms surveyed in the 1993 NSSBF to find that only one-quarter of the smallest firms (but three-quarters of the largest
ones) are financed via bank lending. Hence, smaller firms are more likely to be funded through internal equity capital.
Similarly, Gregory, Rutherford, Oswald, and Gardiner (2005) find evidence that, while smaller firms are more reliant on
finance provided by insiders, larger firms are more likely to employ long-term debt and public equity.
12
Financial capital provided by the owners (equity, loans) increases from 25 to 40% of total financing as the firm
approaches middle age due to earnings accumulation over time (Berger and Udell, 1998).
7
profits, substantial information asymmetries and a lack of collateral, which strongly limits their
access to debt (Carpenter and Peterson, 2002; Fenn and Liang, 1998; and Timmons, 1997).13
Moreover, the interconnectedness of the small- and medium-sized business with the
personal objectives and wealth of the entrepreneur may affect her access to internal/external funds.
In this sense, life style preferences (Petty and Bygraves, 1993), personal financial security and
autonomy (Kuratko, Hornsby and Nafizinger, 1997) and risk preferences (Bolton and Freixas, 2000;
and Xaio, Alhabeeb, Hong and Haynes, 2001) may determine what type of financial capital the
small business owner would obtain.14
Finally, small business finance is also vulnerable to the economic cycle. Macroeconomic
shocks (e.g., equity market disruptions, monetary policy shocks) that are typically transmitted
through the two interest rate-based (bank-lending and balance-sheet) channels of the credit
mechanism and related public policy reactions may lead to a credit crunch for small- and mediumsized firms primarily because of their intrinsic informational opacity.15 Berger and Udell (1998)
suggest that future research should be directed towards investigating about how sources of small
business finance can adapt themselves to business cycle trends and react to related changes in
government policy during times of distress in private or public, financial markets.
3. Empirical Analysis: Data, Econometric Model and Key Findings
The data used in this study are derived from the Surveys of Italian Manufacturing Firms
(SIMFs) by focusing on the following question from the New Investments, R&D and Innovation
section (Section C): “Which forms of financing did you use to fund the new investments in the three13
In this sense, angel and venture capital funding may play a complementary role as firms grow (Freear and Wetzel,
1995). Indeed, the upstart firm would initially solicit angel finance and replace it with VC-based capital as the firm
grows beyond the funding capacity of the angel investor.
14
In particular, Ang (2002) argues that both the goals and risk preferences of the family running the business are critical
in finding the right match between suppliers of capital and small firms. Bolton and Freixas (2000) suggest that while
riskier firms prefer bank loans, safer firms tend to issue shares and bonds to avoid intermediation costs. Xaio et al.
(2001) find that education, age, race and personal net worth are important factors in determining firms’ risk-taking
attitudes and behaviors. Other work suggests that graduate education significantly influences the odds of using external
equity financing by women entrepreneurs (Carter, Brush, Green, Gatewood and Hart, 2003).
15
Papadimitriou and Mourdoukoutas (2002) - focusing on equity financing in U.S., Israel and Ireland - assess the
impact of the” less direct” methods employed in U.S. at public level to stimulate the venture capital industry compared
to the “more direct” methods (such as public-private partnerships and public ownership of venture capital funds)
applied in the rest of the considered countries. Tucker and Lean (2003) examine the equity financing gap faced by small
businesses and investigate about the informal financing initiatives promoted by policy-makers.
8
year period preceding this survey?” (C1.5 within the subsection C1. - Investments). The answer
provided by respondents to such question on the basis of a range of financing options is rearranged
to become the dependent, dichotomous variable of our empirical analysis, which takes the value of
1 if a firm makes use of internal equity capital only and 0 otherwise (e.g., the firm relies on both
internal equity and debt). Figure 1 shows the bipartition of our sample between users of internal
equity capital only and users of a mixed capital structure across the 12 years (1995-2006) surveyed,
with the former being almost one third of our sample.
[INSERT FIGURE 1 ABOUT HERE]
To create a set of independent explanatory variables, we draw questions (with associated
answers) on the behavior of firms in the 3 key functional areas “Labor Market”, “New Investments,
Innovation and R&D” and “Export Strategies, JVs and other forms of International Cooperation”
(from the respective sections B, C and D of the SIMFs) by also adding relevant, general firmspecific information from section A and some important financials, such as the Return on Assets
(ROA) from AIDA TM and the 1-year probability of default from Moody’s RiskCalc TM . In so doing,
we seek to develop a menu of independent variables matching those exploited in similar studies
(referred to in the literature review). The general information includes the company’s age, its size,
its affiliation with one of the Italian industrial districts and its regional location. More specifically,
our menu of eleven independent regressors is aggregated into five different categories: 1. Firm
Characteristics; 2. Industry Characteristics; 3. Regional Location; 4. Firm Financials; 5. Corporate
Strategy & Governance. The first three classes include those variables reflecting general
information (with the exception of the export strategy selected from the section D of the SIMFs).
The residual classes accommodate regressors associated with business operations (drawn from
sections B, C and D). Table 1 provides a detailed definition of such eleven explanatory variables
and reports their descriptive statistics.
[INSERT TABLE 1 ABOUT HERE]
9
We build a pooled logit model to analyze the determinants of internal equity capital use
among Italian manufacturing firms. In this sense, we follow the conventional practice of using a
discrete and limited dependent variable model, where the likelihood of using internal equity capital
for any firm in the surveys is modelled as:
yi  X i  '   i
[1]
where:
1
if yi > 0, i.e. firm i uses internal equity capital only
yi 
[2]
0 otherwise
Xi is the set of exogenous (independent) explanatory variables and  i the error term.
16
The
probability that a firm i makes use of internal equity capital (instead of a mixed capital structure) is
thus measured as follows:
exp X i  '
prob ( yi  1) 
1  exp X i  '
[3]
Because we use data from four distinct surveys, we run an independently pooled cross-section
regression in order to take cross-sectional and time series aspects into account (year-related dummy
variables are included to account for aggregate time effects).17 We also perform some important
controls for: i) age (AGE); ii) size (SIZE); iii) industry sectors; iv) time effects, using a dummy for
different phases of the economic cycle (CYCLE) that is equal to 1 for the 2001-2003 survey (which
reflects a period characterized by worsening economic conditions) and 0 elsewhere.18 19
From equation [3], the logit model may be written in the following log-linear form:
16
For an excellent review of regression models for categorical and limited dependent variables, see Long J. S. (1997).
By pooling random samples drawn from the same population, but at different points in time, we can get more precise
estimators and powerful test statistics. For details on pooled logit regressions, see Wooldridge (2002).
18
See Figure 1 for GDP growth rate in each survey period.
19
For the sake of simplicity, industry-related controls are omitted in Table 2.
17
10
 p 
   0  1 AGE   2SIZE   3 EXP   4 DIST   5SOUTH   6 PERF   7 RISK
log 
1 p 
[4]
  8 INNOV   9 RD  10 GOV  11GROWTH  12 CYCLE  
where p is the probability that any firm (of those surveyed) utilizes internal equity capital (vs. a
mixed capital structure) to finance a new investment project with positive NPV.20 Regression results
are summarized in Table 2 and discussed below.
[INSERT TABLE 2 ABOUT HERE]
Firm Characteristics. Age and size seem not to influence the capital structure choice of Italian
manufacturing firms (the coefficients of such control variables are small in magnitude and not
significant at the conventional statistical level). Export propensity is inversely related to the
probability of only using earnings retention (in place of a mixed capital structure) for financing new
value-creative investments (the associated dummy variable has negative sign and is statistically
significant at the 5% level).
Industry Characteristics. Industry district membership has no significant impact on the likelihood
of an exclusive use of internal equity among the firms surveyed (the coefficient of the associated
dummy variable is small and not statistically significant).
Regional Location. Location in the Southern regions of Italy is also inversely related to the likely
use of internal equity. In other terms, statistical significance at 1% level and negative sign for the
related coefficient imply that those firms financing new investments via earnings retention are
mostly located in the North and Centre of Italy.
Firm Financials. While corporate financial performance proxied for by the ROA is statistically
significant at 1% level with a coefficient of positive sign (the highest in magnitude among all
regressors) indicating that the more profitable firms are, the more likely is that they retain earnings
20
Model [4] is run by using the maximum likelihood estimation method (firm and time subscripts are overlooked for
the ease of exposition). Common statistical tests have been performed to validate the robustness of the model.
11
to finance new positive-NPV investment projects, the degree of risk exposure does not appear to be
a relevant factor in this respect.
Corporate Strategy & Governance. Innovation and R&D capabilities are also inversely related to
potential use of internal equity for pursuing growth opportunities (statistically significant
coefficients at 1% and 5% level respectively, with associated negative signs). This is also supported
by the negative coefficient of the growth-related variable that, though not statistically significant,
indicates that high-growth firms tend to partly leverage their new investments. A family-based
governance model with a high involvement of the members of the founding family in the board has
a positive relationship with an earnings retention-oriented capital structure choice (the related
coefficient has a statistical significance at 1% level and positive sign). Finally, economic cycle (not
surprisingly) seems to influence the financing decisions of firms in that in a worsening business
cycle (with decreasing interest rates) companies are more likely to use external debt in combination
with earnings retention than in a booming economy (the associated coefficient has 1%-level
statistical significance and negative sign).
In sum, the empirical evidence is that firms - which are domestically focused, highly
profitable, not innovative, not R&D-addictive, located in the Northern and Central part of Italy,
family-owned and governed as well as pro-cyclical in their use of equity capital – are more likely to
finance their positive-NPV investment projects via earnings retention.21
Why is internal equity so spread among non-innovative and non-growing, manufacturing
firms that operate in the Italian market (which are statistically represented by almost one-third of
oursample? Can they do any better? In line with previous studies showing that the financing
decisions of family firms are affected by a trade-off between family control and the pursuit of
growth opportunities, our claim is that the prevalence of a family-based corporate governance (G)
model may be at the roots of the tension between high profitability and scarce capacity to innovate
and grow (Wu et al., 2007). The ownership-control identity reflected in family businesses inevitably
21
Our findings are in line with the empirical evidence provided by: a) Michaelas et al. (1998) about the prevalence of
financing for growth based on retained earnings and/or a mixed capital structure among small U.S. companies;
Chittenden et al. (1996) on the likelihood of positive-NPV project funding via earnings retention for more profitable
small and medium-sized firms; Coleman, Shetty and Eppes (2007) on small and mid-sized manufacturing firms
operating in New England (U.S.A.) that are shown to be privately-held, family-owned and highly profitable with a
prevailing exploitation of such earnings for fuelling growth and a lower use of external equity.
12
raises a problem of corporate governance and efficient allocation of resources. Recent studies on the
role of family businesses in the economy have shown that their presence, if dominant, may lead to
conflicting outcomes. If, on one side, they can be seen – in the light of the transaction cost theory –
as intermediate organizational structures between bureaucracy and market, thus allowing to avoid
the incurrence of high transaction and agency costs in a hostile business environment such as that of
the emerging economies (e.g., East Asia, Latin America) where the industrialization process is still
in a take-off phase; on the other, the absence of a corporate governance system within those firms
inhibits the potential for strategic, technological, and organizational innovation. Family firms end
up avoiding innovation and change as well as growth exceeding owners’ resources and management
capabilities, thus favoring the opposite of a creative and innovative environment (Colli, 2003).
Capital structure (or gearing ratio, G) choices are inevitably narrowed: a) external equity capital is
neglected in order to avoid ownership dilution and potential loss of control; b) debt is raised in a
conservative manner to reduce the risk of bankruptcy, which may bring family members out of the
labour market. This creates room for internal equity as the only credible source of capital.
Coherently with the Myers and Majluf (1984)’s signaling model and the resulting pecking order
theory (Myers, 1984), Italian companies make use of earnings retention to avoid the problems of
information asymmetries associated with the other forms of capital.22 But because an innovationdriven growth (G) typically requires a more extensive use of external sources of financing (in the
form of debt and private equity or public share issuances), they are condemned to remain small and
privately-held. The vicious circle that our empirical analysis suggests can be represented according
to the following 3 Gs’ model:
22
Furthermore, as the entry of new shareholders is not allowed by family members and the presence of debtholders is
rare due to the prevailing use of internal equity, any agency problem (with the related costs) associated with equity or
debt becomes irrelevant. This implies that the Jensen and Meckling (1976)’s model does not apply in this context.
13
Governance
(G)
Gearing
(G)
Growth
(G)
Family-based
Governance
Internal Equity
Capital-Only
Financing
Strategies
Low Growth
Therefore, it is clear that all-internal equity firms do not follow an optimal capital structure strategy,
but they are simply forced to finance their business internally (via earnings retention) due to the
restricted views of their family-based governance.
4. The Role of Private Equity Investors: Potential Actions, Market Barriers and Policy
Implications
Based upon recent studies on both access to finance for small and medium-sized firms and
associated management practices and firm selection patterns followed by PE funds, we argue that
private equity may help transforming the Italian “stagnant” manufacturing sector (mainly made of
small and medium-sized businesses unable to innovate and grow) into a more competitive one via a
more disciplined and value-oriented decision-making process.23
Access to PE financing seems to be a good way to dismantle the vicious circle described
above for two key reasons. First, PE may facilitate structural changes within companies at corporate
governance and managerial level (Beck and Demirguc-Kunt, 2006; Bloom, Sadun and Van Reenen,
2009). Second, all-internal equity firms of our sample would be typically targeted by PE funds as
23
More generally, Beck and Demirguc-Kunt (2006), relying on various cross-country evidence, argue that access to
finance via innovative instruments can play a significant role in shaping the small and medium-sized, competitive
business environment. More specifically, Bloom, Sadun and Van Reenen (2009) show that private equity-owned firms
are on average significantly better managed than government, family and privately-owned companies (after controlling
for a number of firm characteristics such as country, industry, size and employee skills). These results arise from use of
a new, robustly-informing survey tool developed by the same authors to collect and measure management practices
(with associated ownership data) across firms and countries (Bloom and Van Reenen, 2007). It is a double-blind
methodology in that both interviewers are not told anything about the financial performance of the firms they interview
(performance blind) and managers are not informed that they are being scored (scoring blind). Such a survey tool is
applied to 4.000 PE-owned and other firms in a sample of medium-sized manufacturing firms in U.S., Europe
(including Italy) and Asia over the 2004-2006 period.
14
they match those criteria systematically underlying optimal selection procedures for a safe value
creation path: a) high profitability (ROA); b) high cash flows (low RISK); c) low leverage or cost of
financial distress (internal equity only); d) lower valuations than sector peers (low GROWTH)
(Opler and Titman, 1993; Aslan and Kumar, 2007; Bharath and Dittmar, 2007; Acharya et al.,
2009).
In particular, PE ownership is shown to enable improvements across a wide range of
management practices within firms with a specific focus on adoption of business operations
techniques and human resource management (Bloom, Sadun and Van Reenen, 2009). Interestingly,
PE-owned firms are better at implementing both modern lean manufacturing and merit-based
hiring, pay and promotion practices removing poor performing employees. Moreover, companies
that persistently remain in the hands of private equity investors are consistently better managed
through time.24 If so, what is the contribution of PE to corporate governance and management
practices of target companies? Next is our attempt to summarize the economics of PE.
PE funds provide equity capital to firms in exchange for a stake in their ownership. By
becoming co-owners (or total owners) of the target (portfolio) companies, PE investors typically
implement a highly value-creating and hands-on governance discipline in all investment stages by
encouraging a proactive agent-principal relationship with existing managers of portfolio companies
(Zong, 2005). Such a discipline is reflected in what Jensen (2007) calls as a new and powerful
model of general management. PE practices enable the capture of value destroyed by agency
problems (mostly failures in governance) in publicly or privately held firms. This is, in brief, how
the PE governance model works. A PE fund is organized in a limited partnership and its equity has
a finite life (not perpetual): capital originally provided must be sent back to investors acting as
limited partners after 7-10 years. Such a temporary investment horizon urges the general partner of
the fund (management company or PE firm) to shift from “growing the business” to “growing the
equity” through setting a natural target performance for board directors, CEO and managers of
portfolio companies. A PE firm’s general partners have a very high reputation and this makes them
excellent board members. Unlike what happens in most corporations, they are not forced to act as
They show, in a three years’ time-lag, the fastest improvement of management practices compared to all different
ownership types.
24
15
employees of the CEO.25 Financial strategy is also crucial. The use of debt and equity is
divisionalized among portfolio companies at the PE fund level, thus leading to higher debt/equity
ratios compared to publicly or privately held, diversified firms. A debt control function is also
performed at the PE fund level: missing the debt service obligations is a more serious disruption
than missing the budget. On one side, the budget process is externalized and negotiated with
suppliers of capital; on the other, debt commitment is set as a performance target below which
compensation is not paid out. This also reduces the temptation to route any free cash flow excess
towards value-destroying investments. Information asymmetries are very limited in portfolio
companies. As a result of an extensive due diligence carried out at the time of the transaction, the
board and the top management are in general more informed about their company than ever before.
Ultimately, PE general partners are active investors in that they are fully involved in the strategic
direction of each portfolio company with the support of the related CEO and top management.
In addition to capital raising from outside investors, PE general partners may invest a
significant amount of their personal wealth in the fund (Kaplan and Stromberg, 2009). Such a
personal share ownership makes the incentive structure of PE investors very similar to that of
family shareholders. Like the members of the founding family, PE general partners are spurred to
enhance the monitoring and control of the firm as well as maximize its value with the additional
advantage of being always (and not discontinuously, as it may happen to the former opting for the
laissez-faire of professional managers) involved in the governance process. The unique discipline
that PE firms impose both internally and on portfolio companies also helps to mitigate two key
agency problems resulting from the separation of ownership and control within modern
corporations (Stiglitz, 1985; Jensen ,1993; Shleifer and Vishny, 1997). Shareholder-manager
conflicts are minimized by active design of strategies, increased monitoring and compensation
schemes aligning the interests of the two. Large-minority shareholder conflicts are avoided due to
firm value maximization that is in common to all types of owners. In essence, PE investors may
replace family shareholders with the aim of reaching the same objectives but making use of better
governance tools. This also explains why family business owners are averse to monitoring actions
25
Practically, the CEOs of PE-owned firms have a “boss” represented by the PE fund’s general partners.
16
that would be brought by public equity financing and prefer involvement of PE funds (Wu et al.,
2007).
Our claim is that an increase in PE ownership across Italian manufacturing firms would
promote a better management style resulting in greater productivity and innovation propensity via a
more efficient allocation of labour and physical as well as financial capital (e.g., asset spin-outs,
targeted personnel layoffs, orderly debt repayment scheduling). A 4x4 matrix may help us
understand the impact of a PE investment on the economic and financial features of those Italian
manufacturing firms that only use internal equity to finance new investments (Figure 2). The group
of firms that in our sample - due to a family-based governance model - are highly profitable, but
non-export oriented, not innovative and R&D-addictive, located in the North and Centre of Italy,
and pro-cyclical in their use of earnings retention are positioned in quadrant III. The (size of the)
red bubble is representative of their (higher or lower) likelihood of using internal equity in
financing new value-creative investments compared to the alternative capital structure decision
(internal equity plus debt) undertaken by the rest of the firms in the sample (blue bubbles; quadrants
I, II and IV).
A PE investor’s access to the capital of red bubble companies may trigger four types of
beneficial managerial actions: increasing export sales (E), fostering innovation (I), improving R&D
capabilities (R&D), rendering governance effective and risk-loving (G). Actions E, I and R&D are
the result of the non-financial support that PE funds may provide to red bubble companies in terms
of transfer of knowledge on how to broaden market focus, reach new geographic areas, or assess
investments in process or product development (Wright et al., 2009). Governance (G) effectiveness
in the form of board members’ focus on all aspects of business operations derives from PE
discipline. Productivity increases by cost cutting and incentive re-alignment. Performance
improvements are associated with the fact that cash (e.g., from non-core asset disposal) is invested
in areas with greater growth opportunities. The combined effect of those actions (as the result of a
more likely use of external equity for financing new, positive-NPV investments) would improve the
competitive advantage of red bubble firms relative to that of blue bubble ones, thus closing the gap
between the two in terms of strategy and management practices. Family businesses in quadrant III
would then be in a better position to exploit their profitability and pursue growth migrating towards
the rest of the quadrants.
17
[INSERT FIGURE 2 ABOUT HERE]
The key policy implication of our empirical analysis is that greater efforts should be made to
promote a more active role of PE investors in the Italian business environment, having small and
medium-sized firms as a specific target. Government interventions directed at implementing
structural changes to PE supply would be crucial in stimulating demand for such type of financing.
In line with the classic debate on the role of the public sector in filling the so called “equity gap” in
the venture capital arena across European countries, we argue that policymakers should also be
challenged to improve access to private equity for those firms operating in their respective
economies at stages of stable growth and business maturity over their life-cycles (Queen, 2002;
Lawton, 2002; McGlue, 2002; Harding, 2002).26 In particular, policy initiatives seem to be urgent in
Italy, where both the academia and the industry argue for the little attractiveness of the country’s
economic system for PE investments. According to a recent study that proposes a composite index
to compare the attractiveness of 27 European countries for VC and PE investors, Italy is ranked
down (with UK instead dominating all other countries) due to its mediocrity in corporate
governance, tax burden and depth of capital markets (Groh et al., 2010). Likewise, three are still the
major supply-side barriers that – according to local PE investors – make the Italian market resilient
to a further growth in demand for PE financing: a) the limited development of the pension fund
market; b) the lack of tax incentives on the extent of deductibility of debt-related interests and, more
in general, on PE business; c) a dedicated role for PE-related turnaround financing within the
bankruptcy law (Bentivogli et al., 2009). Backed by careful studies, corrective policy measures
have been recently proposed by AIFI.27
To contrast the increasing internal competition from international houses that forces Italian
PE firms to do fundraising mostly abroad, PE should become an asset class in pension fund
26
Queen (2002) suggests that an area for public intervention may consist of those companies growing at a belowaverage pace characterized by high risk and low return (and thus not attractive to VCs).
27
AIFI is the Italian Association of Private Equity and Venture Capital, which has identified the key deficiencies of the
Italian PE market in line with the above three barriers indicated by investors: i) limited development of domestic
channels for fundraising; ii) small dimension of the overall market, in terms of number of active PE houses and deals
closed; iii) restricted access to turnaround financing for troubled firms (White Papers, March 2006 and July 2008,
AIFI).
18
investments. For example, pension funds may be allowed to invest at least 10% of their capital into
PE so as to return accumulated pension allowances payable to retired employees (formerly managed
directly by firms and now, by law, by pension funds) to small and medium-sized businesses in the
form of financial, organizational and managerial resources provided by PE professionals.
PE market expansion can also rely upon granting three-fold, advantaged fiscal treatment to
the local sector. First, institutional investors should be fiscally indifferent between investing their
equity capital through the direct purchase of a stake in a potential portfolio company and
committing the same amount of capital to a PE fund (that in turn would potentially invest in the
same company) by becoming one of its limited partners.28 Second, the taxation of the carried
interest should be once and for all aligned with that of the gains earned from financial instruments
(12,5% tax rate; 20% from 2012) due to the common nature of uncertain income.29 Third, the
competitive disadvantage of the Italian buy-out market due to the current limits to interest tax shield
exploitation should be eliminated by increasing the level of deductibility of debt-related interests.30
With the intent of addressing the weakness of the LBO segment, the dominant and most
profitable segment of the Italian PE arena – where the annual issuance of senior debt has decreased
by 91% in five years (€ 5.080 million in 2006 vs. € 460 million in 2010; source: S&P LCD) and the
equity capital (locally and internationally) available for future investments is of about € 2.900
million (source: AIFI-PriceWaterhouseCoopers, June 2011) – we run a simulation on the impact of
28
Fiscal treatment of a PE fund proceeds from liquidation of investments is quite complex in Italy and is different for
individual and institutional investors. To the former, starting from July 2011, the fund distributes gross proceeds, which
are taxed at 12,5% (tax rate applicable to capital gains, dividends, etc.) at individual level. The 12,5% tax rate will raise
to 20% starting from January 1, 2012. Before July 2011, all proceeds were taxed (at 12,5%) at fund level regardless of
their distribution. Even capital gains or dividends only accruing to the fund were subject to taxation. Indeed, the fiscal
treatment of proceeds distributable to institutional investors differs for pension funds and corporate entities (banks,
insurance companies). Proceeds to the former are always taxed at 12,5% (20% from 2012) and thus they are indifferent
between directly investing equity into a company and committing the same equity to a PE fund. Proceeds to the latter
are instead qualified as proceeds generated from a fund (and not from the underlying portfolio company) and are thus
taxed at a higher tax rate (27,5%). This does not apply if the same proceeds are distributed from an holding company
(capital gains are fully exempted from taxation; dividends are exempted at 95% with only 5% of them being taxed at an
effective tax rate of 1,375%). It results that corporate entities would prefer the second mode of investing as opposed to a
PE fund.
29
No uncertainty should be allowed as to the fiscal treatment of the carried interest as capital gain (subject to the 12,5%
tax rate; 20% from 2012) and not as earned income (subject to the 45% tax rate). To avoid disputes with the fiscal
authority and minimize fiscal burden (to 12,5%; 20% from 2012), general partners are still typically asked to make a
commitment of at least 2% of capital to the fund.
30
The current limits of interest deductibility applicable to Newcos established for the purpose of realizing LBOs are not
justifiable if one looks at the cautious and balanced use of financial leverage in recent deal-making that well-matches
the characteristics of target firms (see Table A in the Appendix).
19
an improvement in the interest tax shield mechanism on the potential debt capacity of the 898
internal equity users only as of 2006 (end-year of the most recent SIMF employed here). More
specifically, the Italian fiscal law sets the limit of interest deductibility in 30% of the so called
“fiscal EBIT” (= EBIT + depreciation). If the company’s net interest is equal or lower than the
above fiscal EBIT shield, all financial charges expensed for a given year are fully deductible.31
The theoretical rationale of the exercise lies in the fact that – if the size of potential target
firms’ demand for debt in the buyout market depends (other than on the level of creditworthiness,
CW) upon the expected interest rate ( r E ), which is a function of the spread charged by the bank(s)
over the benchmark (e.g., Euribor) and the degree of fiscal EBIT shield both expected by all target
firms in equilibrium – holding creditworthiness and spread (which are strictly interrelated) constant,
the amount of interest tax shield allowed by the government may be manoeuvred to shift demand
up. Figure 3 shows that a market expectation over the government’s willingness to increase the limit
of interest deductibility raises, for each possible expected interest rate on LBO loans, the total
demand for bank credit (right-hand panel) but leaves the level of creditworthiness unchanged (lefthand panel). In other words, the demand curve shifts out from D1 to D2, while the curve
CW (r E ) remains unchanged. As a result, the improved fiscal benefit encourages potential target
firms to be taken over by interested PE investors, thus driving more activity in the LBO market in
terms of the volume of lending and associated equity injections.
Empirically, the numerical exercise summarized in Table 3 shows that – if the interest tax
shield mechanism is applied (at the current fiscal EBIT shield level of 30%) to those firms
identified as internal equity capital users only within our sample by simulating contraction of some
debt in the future 2006-2009 period – all resulting “virtual” financial charges (net of actual, other
financial interests) would be on average fully deductible with a potential interest coverage ratio
around the safe level of 3x ( the range obtained is 2,6x – 3,2x).32 The only exception lies in the year
2009, which – as it is made apparent by the lower average EBIT – has been hit by the recession
resulting from the 2007-2008 financial crisis. It is interesting to note that, if the fiscal EBIT shield is
The portion of financial charges exceeding such a limit is carried to the next fiscal year for deductibility’s purpose.
More precisely, leasing installments expensed for a given year are also included in the above calculation.
32
The numerical exercise is conducted by normalizing and averaging the relevant items from 2006, 2007, 2008 and
2009 income statements of the 898 internal equity-using firms selected within the 2004-2006 portion of the SIMFs’
overall sample.
31
20
moved up by 50% (from 30% to 45%), the interest coverage ratio remains above the safety gauge of
1,5x.33 Such an exercise demonstrates that PE (leveraged) financing could be furthered in Italy by
creating simple incentives allowing debt-free firms to become buyout targets.
[INSERT FIGURE 3 AND TABLE 3 ABOUT HERE]
Finally, the 2006 bankruptcy law reform – although it has significantly enlarged the set of
crisis management tools available in the country by eliminating the punishment-oriented treatment
of the insolvent entrepreneur that inspired the former regulation – would need some
improvements.34 While until recently Italian distressed firms have had a restricted access to
turnaround financing being forced to go bankrupt with considerable value destruction, it is now
possible to make all efforts to safeguard their assets via use of a gradually more severe range of
credit settlements (negotiable between the company and its creditors both before and after the
court’s declaration of insolvency) and rescue them from the drastic measure of a liquidation
associated with the bankruptcy procedure. Some of the above voluntary arrangements with creditors
are of private nature (“recovery and refinancing plan”) and others are carried out under the control
of the court (“preventive settlement”, “debt re-scheduling”, “bankruptcy settlement”). But all
arrangements involve a recovery plan, the non-cancellation of any transaction executed in
accordance with the restructuring roadmap and the loss of priority (with renouncement to the full
payment of due amounts in favor of less privileged creditors) for those senior debt-holders
accepting the new plan. The recovery plan may allow for any form of turnaround financing and,
under the worst scenario of the start of a bankruptcy procedure, the liquidator is required (by the
court) to preserve (or even enhance) the bankrupt firm value through leasing it out temporarily with
a right of pre-emption granted to the lessee upon liquidation. In this sense, the AIFI suggests that
33
The general rule of thumb suggests that, with an interest coverage ratio below 1,5x, the firm is assumed not to
generate cash enough to satisfy all its debt obligations. In all cases shown in our numerical simulation (except in 2009),
the selected companies can shrink their earnings by a maximum of 68% and still be able to meet potential interest
expenses. Besides that, it must be noted that the safety range of 3x-5x is typically lowered under depressed economic
scenarios with low interest rates, which applies to the 2008-2009 period considered.
34
The reform has abolished the register of bankrupt entrepreneurs by aligning the Italian bankruptcy law to those of
other countries such as Germany (Insolvenzordnung, 1999), France (Loi de sauvegarde des enterprises, 2005), and U.K.
(Insolvency Act, 1986; Enterprise Act, 2003).
21
further value destruction would be avoided if the liquidator could select a PE firm specialized in
turnarounds as a “temporary manager” of the bankrupt company (for 12 months, only renewable
once). While avoiding further damages to the creditors, the PE firm would have the purpose of
restructuring the company (instead of keeping it alive as a going-concern entity for its subsequent,
pure liquidation) with an option to buy it at the end of the bankruptcy procedure. In order for the
liquidator to do so, the temporary leasing framework should be extended and a purposely designed
contractual mechanism allowing for the involvement of a PE investor should be introduced in the
Italian bankruptcy law.
Despite the importance of supply-side measures for developing the PE market in Italy, it
should be noted that an enduring demand boost would only be achieved if a cultural change among
founding family owners of small- and medium-sized, mature Italian manufacturing firms is
promoted through transparency and information (e.g., publicity of successful stories) (Harding,
2002).
The high potential for Italian PE, as it emerges from our empirical evidence, is confirmed by
the flourishing activity recorded in the country market since 2006 (the end year of our 2004-2006 X
Survey). As most European markets decline, PE investments in Italy increase by 30% between 2007
and 2008 with an exceptional growth also in the number of companies invested and a steady rise in
the size of the average investment.35 The pattern of yearly IRRs shows that the Italian PE market
performance has declined over the 2007-2009 period until it has turned into a negative one (-16.6%;
2009) due to the global crisis. However, an historical 24-year IRR of 27.6% (1986-2009)
demonstrates that PE investments realized in the country may be highly profitable on average. 36 The
financing stage preferred by PE firms for their exit is expansion/development both in 2009 and
historically, even though the leveraged transactions (MBO/MBI) represent the prevailing form of
investment at inception (43%) and provide the highest historical performance (44.8%).37 The
PE investments: € 5,5 billion (2008) vs. € 4,2 billion (2007) (Grant Thornton - GT, June 2009). Number of companies
invested: 284 (2008) vs. 251 (2007); +13% (GT, 2009). Average investment: € 19,9 million (2009) vs. € 16,4 million
(2007), with an historical average of € 7,5 million in the 1986-2009 period (KPMG-AIFI Survey, May 2010).
36
Both annual and historical pooled IRRs reported in the KPMG-AIFI Survey are calculated on the basis of those
investments and the associated divestments of a minimum 30% equity stake made in 2009 or across the whole 19862009 period respectively.
37
In 2009, the new PE investments are made using the following type of financing: buy-out (43%),
expansion/development (35%), turnaround (16%), replacement (6%) (Private Equity Monitor, May 2010).
35
22
majority of divestures involves minority stakes (< 50%) both in 2009 and historically (97% vs.
88%) with an average focus on the 10%-50% range (62%; mean IRR = 24.2%) and an average
holding period of up to five years (73% of deals). The new investments in the predominant form of
acquisition of a 51% stake (and the related divestures) are mainly in small-medium sized companies
(< € 50 million sales) located in Lombardy, manufacturing industrial products and priced on
average (in 2009) at an EV/EBITDA equal to 5,7x (Private Equity Monitor, May 2010). The
common origination of all deals is private (family business). This has led PE investors to currently
hold 5,2% of Italian small-medium sized companies in their portfolios, which represents 15% of the
country’s GDP (See Tables A and B in the Appendix).
As far as the sector’s prospects are concerned, it should be noted that the Italian PE market
is estimated to be growing in the near future, as € 8.115 million is the amount of equity capital that
the main houses have still available to invest (Figure 4). In this sense, PE investments in the country
have steadily increased since 2006 representing 1,2% of total worldwide market in 2010 with a
+35% growth compared to 2009 (0,9%; 2009 market share of Italian PE vs. Rest of the World). It is
yet unclear how much of this capital will be raised domestically, as the main institutional investors
operating in the country are still lowly attracted by PE and more than 50% of the Italian fundraising
is performed internationally (Bentivogli et al., 2009).
This study offers some important managerial insights. On one hand, our findings may assist
general partners of PE firms in exploring more investment opportunities in the Italian
manufacturing sector as there are several small and medium-sized enterprises that would gain from
rejuvenating their business model through the value-oriented discipline imposed by a PE ownership.
On the other hand, this research should motivate owner-managers of the most part of family
businesses, who still refrain from resorting to external equity to seek to capitalize on future growth
opportunities in cases of succession or not, to look at PE as an excellent companion for getting out
of the stagnation trap and engaging in a new, innovation-driven path. PE funds can help those firms
assigned to quadrant III of the above impact matrix to complement their existing (tangible and
intangible) resources with new ones that would be otherwise difficult to access. PE firms would
obtain such resources from the market thanks to their own social capital of network connections
with the outside business environment and would succeed in integrating them more objectively
because of the absence of emotional ties to target companies’ founding families (Dawson, 2011).
23
Missing growth opportunities due to a myopic financial strategy would represent a disgrace for the
Italian economy.
Although we offer several policy and managerial implications, our analysis suffers from
some limitations and constraints that bring to light avenues for future research. One limit is due to
the fact that, while we attempt to provide an explanation for the abuse of earnings retention among
Italian manufacturing firms and its negative consequences as to their sluggish presence in the
market, our argument that access to PE financing would significantly improve their business model
cannot be supported by supplemental empirical evidence. Indeed, the characteristics of exclusive
internal equity users in our sample perfectly match those of the average portfolio company of PE
investors operating in the Italian market. However, it would be interesting to verify whether the
above firms have been subsequently targeted by PE investors or not. Additionally, our study is
constrained by the exogenous design of the questionnaires (prepared by Unicredit Group for the
specific purpose of the SIMFs), which does not allow to address, for example, further issues linking
the corporate governance and agency theory literature and the use of private equity financing by
small and medium-sized businesses and concerning the influence of the interaction between family
ownership (e.g., more or less than 50%) and agency cost control mechanisms (e.g., frequency of
board meetings) or of the owner’s personal attributes (e.g., level of education) on capital structure
decisions of small and medium-sized enterprises (Wu et al., 2007).
In light of the above, two directions for future research seem very promising. First, we aim
to enhance our dataset collecting data on firms that operate in the Italian manufacturing sector and
have been backed by private equity finance after 2006. Looking at actual PE deals executed
subsequently to the period covered in our analysis would permit to overcome the key limitation of
the present study that only relies on official market figures to validate the argument according to
which the country’s stagnant manufacturing sector should become a potential platform for
outperforming PE investments. Second, although the proposal of all demand- and supply-side
measures needed for enhancing the functioning of the country’s PE business is beyond the scope of
our study, the findings presented here indicate that the development of a PE market should be
prominent in the policy agenda of the Italian government. Hence, it would be interesting to
elaborate more on the recommendations that should be directed to policymakers in Italy and in
24
other European countries where the pace of PE investments is slow in order to advance the
entrepreneurial culture for the use of external equity.
In closing, our work represents a further step towards understanding how PE finance can
contribute to improving the entrepreneurial model of small and medium-sized businesses.
[INSERT FIGURE 4 ABOUT HERE]
5. Conclusions
Our econometric analysis provides the clear picture of a significant portion (one-third,
numerically across the surveyed years; 0,75% of Italian GDP in 2006, in terms of total value added)
of the Italian manufacturing sector which, although it could potentially serve as the driver of the relaunch of the country’s economy, is financially myopic and operationally stagnant. Such part of the
sector is comprised of firms of any size (but especially small and medium) that – more likely (than
the rest of manufacturing companies) to make an exclusive and pro-cyclical use of internal equity
capital to finance their new investments – are mainly located in the Northern and Central part of the
country and tend to be steadily profitable but not export-oriented, not innovative and R&D
spenders. More interestingly, their dominant family business model determines an inefficient
allocation of organizational and financial resources, thus preventing the pursuit of growth-oriented
strategies for sustaining competitive advantage.
Our suggestion is that a rejuvenation of business operations of such mature enterprises
should start from a change in their financial strategy. To some extent, the role of family
shareholders could be taken over by PE funds with a greater, active involvement and better
incentives. A (partial) re-allocation of firms’ ownership in favor of PE investors (based on a
qualitative change to the gearing ratio, G) would permit to create more value (from growth, G) via
improvement of governance (G) style and management practices. Hence, stronger policy efforts are
required to further PE activity in Italy by removing the key barriers that still prevent it from
growing at a larger scale (e.g., development of the pension fund market, additional fiscal incentives,
and amendments to the bankruptcy law). This would allow (both incumbent and new) external
equity investors to target potentially valuable companies and private equity – in general, as an asset
class – to eventually have a positive, real impact on the real economy of the country.
25
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31
Figure 1 – Sample Statistics on Use of Internal Equity vs. Mixed Capital among Italian
Manufacturing Firms (SIMFs , 1995-2006)
Internal Equity Capital
Mixed Capital (Internal Equity + Debt)
5,000
4,500
Real GDP =
3,90%
Real GDP =
2,60%
Real GDP =
0,10%
4,000
Real GDP =
2,57%
N° OF FIRMS
3,500
3,000
2,500
3,112
(76%)
3,191
(74%)
2,542
2,000
(73%)
(73%)
2,098
(70%)
1,500
1,000
500
975
1,103
955
(26%)
898
(24%)
(27%)
(30%)
1995-1997
1998-2000
2001-2003
2004-2006
Total Firms:
Total Firms:
Total Firms:
Total Firms:
4,087
4,294
3,497
2,996
(26%)
0
SURVEYS OF ITALIAN MANUFACTURING FIRMS (SIMFs)
32
Table 1 – Definitions and Descriptive Statistics of the Independent Explanatory Variables Used to
Map the Managerial Style and the Operational Practices of Italian Manufacturing Firms Using
Internal Equity vs. Mixed Capital (SIMFs , 1995-2006)
Name
Notation
Definition of the
variable
Mean
Standard
Deviation
Min
Max
Firm Characteristics
Age of the Firm since
establishment (a)
Number of employees
(b)
Dummy variable = 1 if
firm exports, else = 0
28.04
18.5
1
191
113.15
383.54
11
12,630
0.71
0.45
0
1
DIST
Dummy Variable = 1 if
firm belongs to a
District, else = 0 (c)
0.19
0.39
0
1
SOUTH
Dummy Variable = 1 if
firm is located in the
South, else = 0 (d)
0.14
0.35
0
1
0.04
0.06
-0.29
0.30
0.01
0.02
0.00
0.24
0.65
0.47
0
1
0.41
0.49
0
1
0.07
0.07
0
1
-2.51
122
0
1
Age
AGE
Size
SIZE
Export
EXP
Industry Characteristics
Industrial District
Regional Location
Southern Regions
Firm Financials
Performance
Risk
ROA
RISK
Firm’s ROA (e)
Firm’s 1-year
probability of default
(RiskCalc Italy™) (f)
Corporate Strategy & Governance
Innovation
INNOV
Research &
Development
RD
Governance
GOV
Growth
GROWTH
Dummy Variable = 1 if
firm innovates, else = 0
(g)
Dummy Variable = 1 if
firm incurs R&D
expenses, else = 0
Percentage of family
members involved in the
firm’s management (h)
Yearly Change in the
number of employees (i)
Source: Our elaborations on Unicredit Group’s Surveys of Italian Manufacturing Firms (SIMFs) and on AIDA™
database over the 1995-2006 period.
(a) n° of years since establishment. Data as of years 1997, 2000, 2003, and 2006.
(b) data as of years 1997, 2000, 2003, and 2006.
(c) reference is made to the 64 industrial district areas identified by Mediobanca (2004) for the Italian manufacturing
sector. Each district is coded by combining the location (province) with the industrial sector (classified according to
the ISTAT’s ATECO system).
(d) firms are considered to be in the South of Italy if located in the following regions: Abruzzo, Basilicata, Campania,
Molise, Apulia, Sardinia, and Sicily.
33
(e) data are derived from the AIDA™ database by Bureau Van Dijk (that contains financial information on 280,000
Italian companies) and are referred to years 1997, 2000, 2003, and 2006.
(f) developed by Moody’s KMV (2002, 2005). RiskCalc™ Italy, firstly released in October 2002 and regularly
revised, is the first Basel 2-compliant rating model based on publicly available data to assess a private firm’s
creditworthiness, and constitutes a benchmark in the Italian financial industry. Details on the variables included in
such a model and their related weights are available upon request.
(g) innovation is referred to product and/or process advancement.
(h) n° of the members of the founding and owning family present in the board and involved in day-to-day business
operations of the firm to total employees as of the last year of each survey. It captures the corporate governance and
managerial style of each company by seeking to discriminate between the firms where the family retains voting
control over the strategic direction of the business and multiple generations of family members are directly
involved in day-to-day management (family businesses) and those whereby, regardless of a family or non-family
ownership, the separation between shareholders and managers is strong (non-family businesses). In this sense, we
adopt the most stringent definition of a family firm among the three elaborated by Astrachan and Shanker (2003).
(i) measured between the second and third year of each survey (e.g., for the 2005 survey, the growth in the number of
employees is referred to the 2002-2003 period).
34
Table 2 – Econometric Analysis (Pooled Logit Model)
Independent Variable
Parameter
Standard Error
Probability
Intercept
-0.8337***
0.0970
0.0000
AGE
0.0002
0.0002
0.2797
SIZE
-0.0001
0.0001
0.6865
EXP
-0.1192**
0.0512
0.0200
DIST
-0.0332
0.0637
0.6018
SOUTH
-0.3027***
0.0690
0.0000
ROA
2.0994***
0.3729
0.0000
RISK
-1.1364
1.3547
0.4015
INNOV
-0.5316***
0.0465
0.0000
RD
-0.1017**
0.0499
0.0417
GOV
1.0936***
0.2816
0.0001
GROWTH
-0.0003
0.0002
0.1416
CYCLE
-0.2331***
0.0481
0.0000
No. of Obs.
2
14,874
Pseudo R
0.0322
Likelihood Ratio (LR)
432.9073
Probability LR
0.0000
Obs with Dep = 0
10,943
Obs with Dep = 1
3,931
Source: Our elaborations on Unicredit Group’s Surveys of Italian Manufacturing Firms (SIMFs) and on AIDA™
database over the 1995-2006 period.
Notes: *, **, *** indicate statistical significance at the 10%, 5%, and 1% respectively.
35
Figure 2 – Matrix for Mapping the Impacts of Private Equity Investment on the Economics and
Financials of Italian Manufacturing Firms Using Internal Equity Capital Only
PROPENSITY TO
INNOVATION
PROFITABILITY
I
II
GEOGRAPHIC
LOCATION
(North vs. South)
EXPORT
INCREASING EXPORT SALES
FOSTERING INNOVATION
III
IV
(I)
(E)
GROWTH
CORPORATE
GOVERNANCE
(R&D)
IMPROVING R&D CAPABILITIES
(G)
RENDERING GOVERNANCE
EFFECTIVE AND RISK-LOVING
CYCLE
R&D
Legenda:
= probability of using a mixed capital structure to finance new investments
= probability of using internal equity capital only to finance new investments
= private equity-driven action (impact of a private equity investment on
governance and management practices of firms using internal equity capital
only)
36
Figure 3 – Upward Shift of Demand for LBO Loans When Market Expects an Improvement in the
Interest Tax Shield by Government
Level of Target’s
Creditworthiness (CW)
Total Lending in the
Buyout Market (L)
CW (r E )
S
D2
D1
r2E r1E
Expected Interest
Rate on LBOE
related Loans ( r )
37
r1E r2E
Expected Interest
Rate on LBOE
related Loans ( r )
Table 2 – Interest Tax (or “Fiscal EBIT”) Shield Numerical Simulation (2006-2009)
Fiscal EBIT Shield= 30%
Year
2006
2007
2008
2009
Average
Average EBIT Depreciation
3,167,657
1,821,094
3,659,974
1,831,926
1,777,674
1,760,237
249,271
1,842,455
30%*(EBIT+Depreciation)
1,496,625
1,647,570
1,061,373
627,518
Other Average Net
Financial Interests
-300,885
-305,723
-500,408
-304,839
Deductibility of
Current Net Interests
Full Deductibility
Full Deductibility
Full Deductibility
Full Deductibility
Potential
Deductibility
1,195,740
1,341,846
560,965
322,679
Potential Interest Potential Earnings
Coverage Ratio
Shrinkage
2,6x
62%
2,7x
63%
3,2x
68%
0,8x
-29%
Other Average Net
Financial Interests
-300,885
-305,723
-500,408
-304,839
Deductibility of
Current Net Interests
Full Deductibility
Full Deductibility
Full Deductibility
Full Deductibility
Potential
Deductibility
1,445,178
1,616,441
737,861
427,265
Potential Interest Potential Earnings
Coverage Ratio
Shrinkage
2,2x
54%
2,3x
56%
2,4x
58%
0,6x
-71%
Other Average Net
Financial Interests
-300,885
-305,723
-500,408
-304,839
Deductibility of
Current Net Interests
Full Deductibility
Full Deductibility
Full Deductibility
Full Deductibility
Potential
Deductibility
1,694,615
1,891,036
914,756
531,851
Potential Interest Potential Earnings
Coverage Ratio
Shrinkage
1,9x
47%
1,9x
48%
1,9x
49%
0,5x
-113%
Other Average Net
Financial Interests
-300,885
-305,723
-500,408
-304,839
Deductibility of
Current Net Interests
Full Deductibility
Full Deductibility
Full Deductibility
Full Deductibility
Potential
Deductibility
1,944,053
2,165,631
1,091,652
636,438
Potential Interest Potential Earnings
Coverage Ratio
Shrinkage
1,6x
39%
1,7x
41%
1,6x
39%
0,4x
-155%
Fiscal EBIT Shield= 35%
35%*(EBIT+Depreciation)
2006
2007
2008
2009
1,746,063
1,922,165
1,238,269
732,104
Fiscal EBIT Shield= 40%
40%*(EBIT+Depreciation)
2006
2007
2008
2009
1,995,501
2,196,760
1,415,165
836,690
Fiscal EBIT Shield= 45%
45%*(EBIT+Depreciation)
2006
2007
2008
2009
2,244,938
2,471,355
1,592,060
941,277
38
Figure 4 – Equity Capital Resources Available for Private Equity Investments in Italy vs. Rest of
the World and Related Market Shares (2006-2010)
€ 800.000
EQUITY CAPITAL
AVAILABLE FOR PE IN
ITALY
€ 700.000
(0,9%)
€ 500.000
€ 5.160
(0,9%)
€ 400.000
€ 300.000
€ 6.301
(1,1%)
€ 5.955
€ 600.000
€ 8.115
€ 7.510
(1,2%)
(0,9%)
-20%
+35%
+24%
Growth Rate in the Market
Share of PE Investments in
Italy (vs. Rest of the World)
Stable
Market Share of
PE Investments
in Italy (vs. Rest
of the World)
EQUITY CAPITAL
AVAILABLE FOR PE
WORLDWIDE
€ 200.000
€ 100.000
€0
2006
2007
2008
Market for PE Investments (Rest of the World)
2009
Market for PE Investments (Italy)
Data in € million
Source: AIFI-PriceWaterhouseCoopers (Italy) and Prequin (Rest of the World), June 2011
39
2010
APPENDIX
Table A – Key Features of the Italian Private Equity Market (2007-2009)
Key Features of the Italian Private Equity Market
2007
# of PE houses participating in the survey
66
# of PE houses reporting realized investments
33
# of realized investments since inception
99
Average Investment Size (€ million)
16.4
Average Total Sales (€ million)
34.0
Average Debt to Equity (D/E)
1.4
Average Price Paid (EV/EBITDA)
6,7x
Yearly Pooled IRR
29.2%
Yearly Pooled IRR (Upper Quarter per Performance)
81%
2008
71
38
78
16.5
40.0
1.4
6,8x
18.9%
51%
2009
75
23
42
19.9
32.0
1.0
5,7x
-16.6%
34%
Source: KPMG-AIFI Survey, May 2010; Private Equity Monitor, May 2010
Table B – Historical IRR (since Inception) Analysis of the Italian Private Equity Market (19862009)
Historical IRR since Inception Analysis (1986-2009)
# of PE houses reporting realized investments
80
# of realized investments since inception
953
Average Investment Size (€ million)
7,5
Historical Pooled IRR
27.6%
Financing Stage
# of transactions
Historical Pooled IRR
% of Acquired Stake
# of transactions
Incidence
Historical Pooled IRR
Time Gap between Investment and Divesture
# of transactions
Incidence
Historical Pooled IRR
Early Stage Development
87
346
29.0%
16.5%
MBO/MBI Replacement
272
112
44.8%
29.2%
<5%
95
12%
16.0%
5%-10%
117
14%
23.4%
10%-25%
265
32%
18.4%
25%-50%
245
30%
30.0%
>50%
97
12%
41.7%
<2 years
222
23%
82.0%
2-3 years
217
23%
54.0%
3-4 years
143
15%
51.5%
4-5 years
111
12%
17.8%
5-7 years
163
17%
7.1%
Source: KPMG-AIFI Survey, May 2010
40
>7 years
97
10%
6.9%