Private Equity: Italy

A Q&A guide to private equity law in Italy

This Q&A is part of the PLC multi-jurisdictional guide to private equity. It gives a structured overview of the key practical issues including, the level of activity and recent trends in the market; investment incentives for institutional and private investors; the mechanics involved in establishing a private equity fund; equity and debt finance issues in a private equity transaction; issues surrounding buyouts and the relationship between the portfolio company's managers and the private equity funds; management incentives; and exit routes from investments. Details on national private equity and venture capital associations are also included.

For a full list of recommended private equity lawyers and law firms in Italy Country Q&A tool. For a full list of jurisdictional Q&As visit www.practicallaw.com/privateequity-mjg.

Market overview

Reform

Tax incentive schemes

Fund structuring

Investment objectives

Fund regulation and licensing

Investor protection

Interests in portfolio companies

Buyouts

Principal documentation

Buyer protection

Debt financing

Lender protection

Financial assistance

Insolvent liquidation

Equity appreciation

Portfolio company management

Exit strategies

Private equity/venture capital association

Italian Private Equity and Venture Capital Association (Associazione Italiana del Private Equity e Venture Capital) (AIFI)

Contributor details

Franco Agopyan

Market overview

Private equity funds based in Italy continued to have a diverse investor base in 2010. Approximately 2% of the capital raised was sourced from overseas (a decrease from the 2009 figure of 32%). The sources of funding were:

The above statistics are sourced from Il mercato italiano del Private Equity e del Venture Capital nel 2010 published by the Italian Private Equity and Venture Capital Association (Associazione Italiana del Private Equity e Venture Capital) (AIFI) (AIFI Statistics) (see box, Private equity/venture capital association).

The global credit crisis and economic downturn continued to affect the size, nature and terms of private equity transactions entered into in 2010. After 2008 was characterised by record investment activity figures in terms of both the amount and number of completed deals, the Italian private equity and venture capital market experienced a slowdown in 2009 and 2010 due to the global financial crisis of 2009. 2011, however, seemed to show new signs of recovery considering that the aggregate amount of the private equity transactions entered into in the first half of 2011 totalled EUR1,524 million (as at 1 November 2011, US$1 was about EUR0.7) marking an increase of 176% compared to the figure recorded in the same period of 2010.

Data sourced from the AIFI-PricewaterhouseCoopers report shows that the total amount of capital raised by funds operating in Italy in 2010 increased to EUR2,186 million, which represents a considerable increase from 2009 levels, when new capital raised reached EUR957 million.

Investment activity in 2010 saw 292 new deals, distributed over 226 companies, for a total amount invested of EUR2,461 billion (substantially in line with 2009). Across the whole market, the average invested amount per deal is substantially the same as in 2009 at EUR8.4 million (and EUR29.4 million including large and mega deals completed in 2010).

During 2010, the total amount divested, calculated at cost (that is, not including capital gains), was EUR977 million (a decrease from EUR1,821 billion in 2009), while the total number of divestments was 123 (a decrease from 2009, when the number was 143), distributed over 112 companies (in line with 2009). The amount of write-offs decreased substantially in comparison to 2009 (11% of write-offs in 2010 compared to 39% in 2010), and the amount of trade sale or secondary divestments increased, a sign of recovery in the market.

Fundraising

Funds raised by private equity firms in 2010 totalled EUR2,187 million, compared to EUR957 billion in 2009. Funds raised were for the following:

Investments

Private equity investments were made in 226 companies in 2010, substantially in line with 2009. The total value of all private equity investment in Italy slightly decreased from EUR2,615 billion in 2009 to EUR2,461 billion in 2010.

The main sectors targeted by private equity investments in 2010 were:

Transactions

The investment amounts by stage in 2010 were (AIFI statistics):

Exits

Exits accounted for EUR977 million in 2010, compared to EUR1,821 recorded in 2009, while exits in the first half of 2011 accounted for EUR2,337 million, compared to EUR470 million in the same period of 2010 (AIFI statistics). The distribution of exits in 2010 was as follows:

Reform

On 16 March 2010, the Bank of Italy issued a consultation document containing proposals that could affect the governance of private equity funds and the procedures for the approval of the funds' rules. These proposals, which are at a preliminary stage and are yet to be enacted, would introduce certain requirements for advisory committees (the bodies in which investors are represented) including with respect to:

Decree no. 78 of 31 May 2010, as amended by Law no. 122 of 30 July 2010, among other things, has set out a new tax framework for funds and is shortly expected to come into force.

Changes to the Italian Banking Law (no. 385 of 1 September 1993), aimed at implementing Directive 2007/44/EC amending Directive 92/49/EEC and Directives 2002/83/EC, 2004/39/EC, 2005/68/EC and 2006/48/EC as regards procedural rules and evaluation criteria for the prudential assessment of acquisitions and increase of holdings in the financial sector, have removed certain restrictions on making an investment or purchasing a controlling interest in a bank by entities other than banks, including private equity funds.

On 13 July 2009, the European Parliament and the Council adopted Directive 2009/65/EC on the co-ordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) which introduces a deep reform to the rules contained in the current Directive 85/611/EEC on undertakings for collective investment in transferable securities (UCITS Directive). The reforms are aimed at simplifying the regulatory environment by:

Directive 2009/65/CE, together with the following represents the UCITs IV regime applicable in Italy since 1 July 2011:

Taking into account the direct effectiveness of the two regulations in Italy, as well as some provisions of the Directives that are deemed, in light of settled case-law, self-executing due to their clear, precise and detailed content, the National Commission for Companies and the Stock Exchange (Commissione Nazionale per le Società e la Borsa) (Consob) has provided, in agreement with the Bank of Italy, some preliminary instructions to clarify the rules applicable from 1 July 2011.

In addition, the Ministry of Economics and Finance (Ministero dell'Economia e delle Finanze) issued a consultation document (7 April 2011) to implement UCITs IV at a legislative level and conversely Consob and Bank of Italy issued a consultation document (11 May 2011) on the implementation of UCITs IV at a regulatory level.

On 8 June 2011 the European Parliament and the Council adopted Directive 2011/61/EU on alternative investment fund managers (AIFMs), which were designed to create a comprehensive and effective regulatory and supervisory framework for AIFMs. The directive, which may affect the management of private equity funds, includes, among other things:

None of these EU directives has yet been implemented in Italy.

Tax incentive schemes

There are no special incentive schemes to encourage investment in non-listed companies.

Fund structuring

The most commonly used private equity fund is the closed-ended investment fund (società di gestione del risparmio) (SGR). The structure is well adapted to the process of selection, managing, monitoring and divestment of investments in the private equity industry, as:

Decree no. 78 of 31 May 2010, as converted in Law no. 122 of 30 July 2010, strengthened the plurality of the fund's participants and the independence of the SGR, introducing a new definition of investment fund in the Legislative Decree no. 58 of 24 February 1998. In addition, Decree no. 78 of 31 May 2010 also strengthened the separation between the assets of the SGR and the fund.

SGRs are similar to limited partnerships organised under English law, with dissociation between managers, fund sponsors and third party investors. However, SGRs are more strictly regulated (to provide protection to retail investors) than limited partnerships and therefore there is less room for contractual autonomy.

Other legal structures that may be used include:

Foreign legal structures commonly used to invest in Italy include the:

OICR

Italian Investment Funds (OICR) are not subject to ordinary income taxes and any tax on the accrued increase of net asset value. Investors are subject to a withholding tax at a standard rate of 20%, levied on the periodical income distributions and the (positive) difference between the value of redemption or disposal of the investment and the weighted average purchase/subscription price of their investment. Interest income, dividends and capital gains are received by the fund gross of withholding taxes (with some exceptions), and contribute to the year-end operating result of the fund.

Investor income is taxed as either capital income or capital gains.

Investor capital income. This includes:

The tax treatment depends on the investor's tax residency:

Investor capital gains. Profits realised by an investor through the sale of units, in excess of any capital income, are considered to be a capital gain (or a capital loss, as the case may be).

The tax treatment depends on the investor's tax residency:

Other structures

Joint stock companies, limited liability companies, partnerships limited by shares and co-operative and mutual insurance companies (see Question 6) are subject to corporate income tax while resident companies are taxed on their worldwide income.

The ordinary IRES rate is 27.5%.

Capital income and capital gains received by an Italian company from unit holdings benefit from a 95% discount on their taxable base, subject to certain conditions, for an effective tax rate of 1.375%. Neither a minimum holding percentage nor a minimum holding period is required to benefit from this exemption.

Any dividends paid by Italian companies are taxable in Italy. A 20% final withholding tax is levied on dividends paid to both companies and individuals. For certain specified EU-resident companies, the final withholding tax rate for dividends received is 1.375%. These withholding taxes may be reduced or eliminated under an applicable double tax treaty.

Partnerships are treated as transparent entities and are not subject to corporate income tax, while their partners are directly taxed on their share of the partnership's profits.

Non-resident companies are generally regarded as opaque vehicles.

Investment objectives

Private equity funds typically seek to achieve medium-term capital gains on their investments, which are usually measured in terms of internal rate of return (IRR) multiples. Historically, private equity funds have targeted annual returns of 20% and above, although the economic downturn could change these expectations.

The average term of a private equity fund ranges from three to five years. During the investment and commitment period, the fund manager may require the investors to draw down new investments, while the remainder of this period is used by the manager to increase the value of the portfolio investments and seek profitable exit opportunities.

Fund regulation and licensing

SGRs are treated as financial intermediaries, which must be authorised by the Bank of Italy to provide collective portfolio management services. SGRs must be set up as joint stock companies and have a minimum share capital of EUR1 million. SGRs' directors and auditors must satisfy certain reputation, professionalism and independence requirements, while SGRs' shareholders must satisfy certain reputation requirements. An SGR's authorisation is subject to assessment by the Bank of Italy of its programme of activity and organisational structure.

An SGR that manages private equity funds typically comprises:

SGRs can manage private equity closed-ended funds set up by them or by other SGRs. If SGRs lack the capabilities to manage a business or investment internally, they can delegate the management of one or more stages of the investment activity to third party advisors without avoiding responsibility for the activities carried out by them.

Regulation

Private equity funds are treated as common funds and, together with other forms of investment, are considered to be collective investment undertakings.

Italian private equity funds may or may not be reserved to qualified investors. Unless the offering of a private equity funds' units (of either reserved or unreserved common funds) falls under the rules for a public offering of securities, the units can be distributed under a private placement regime.

However, the public placement of private equity funds' units requires prior approval by Consob and the publication of a prospectus.

An SGR can market the fund units directly, at its offices through distance marketing techniques or tied agents (promotori finanziari), or indirectly through one or more placement agents.

Exemptions

The prior approval of the prospectus by Consob and the publication of a prospectus is not requested if any of the following exemptions apply:

The offer involves open-end collective investment undertakings whose minimum subscription amounts equate to at least EUR250,000.

As a general rule, no nationality or number restrictions are imposed on investors in private equity funds.

Qualified investors must fall within one of the following categories:

Natural and legal persons and other entities with specific knowledge and experience in securities transactions

There are no statutory limits on investment periods in private equity funds, except that the maximum duration of a common fund cannot exceed 50 years.

For some specific funds, investors may be required to subscribe for a minimum quota of EUR50,000 each.

For funds that are restricted to qualified investors, units can only be transferred to persons and entities included within specific categories (see Question 12).

The fund rules may contain other restrictions.

Investor protection

The relationship between investors and the private equity fund is governed by the fund rules. Approval of the fund's rules by the Bank of Italy is not required for funds reserved to particular categories of investors.

Typical protection terms that investors seek in the fund rules include:

Provisions regulating the meeting of participants of closed-end funds were issued in 2010. The rules of a closed-end fund must identify the issues for which meetings of participants must be called to adopt resolutions that are binding on the SGR. In any case, the meeting of participants must be called to vote on the replacement of the SGR admission to listing (where this is not provided for) and changes to the investment policy.

It is common for a newly established fund to adopt rules aimed at facilitating fundraising on both domestic and international markets in line with international best practices.

Interests in portfolio companies

Common forms

In a typical buyout, a company is acquired by a specialised investment firm, the private equity fund, using equity and bank loans. Equity is provided by the private equity fund, the target company's management (either incumbent or new) and, occasionally, the seller.

A typical equity package comprises both true equity, in the form of ordinary shares or preference shares (whether convertible or not) or a combination of these, and quasi-equity, usually in the form of a subordinated shareholder loan. Generally, management equity consists of ordinary shares only.

A preference share is a form of hybrid security. Preference shares differ from ordinary shares in that they generally have a preferential right to receive dividends and participate in any distribution on liquidation of the company. A convertible preference share, in addition to the traditional preference share rights, entitles the holder to convert it at some future point into another security, such as an ordinary share.

The issuance and transfer of shares in a company are not themselves subject to any legal restrictions. However, the company's bye-laws or the shareholders' agreement generally give restrictions on the transfer of shares, such as tag-along, drag-along rights and similar provisions, which entitle the private equity fund to force the other shareholders (and give them the right) to sell their shares on exit. The management team is typically prohibited from transferring their shares until exit and is subject to good and bad leaver provisions under their service agreements.

Investor loans are often used because of their tax advantages. Typically, they have a long maturity and interest payment is capitalised due to restrictions on dividends and other payments under the acquisition finance package. They are generally treated as if they were equity by acquisition finance providers because of these characteristics.

For an overview of the main forms of debt financing, see Question 23.

Buyouts

In the last few years, and particularly before the deterioration of market conditions, auctions have become fairly standard for buyouts of private companies. Although there are no specific laws or rules governing auctions, these procedures generally follow a specific path. First, a limited number of potential buyers are contacted by the seller's financial advisers. After signing a non-disclosure agreement, interested buyers receive an information memorandum with information on the target company and its business. Buyers are then invited to submit indicative, non-binding offers, following which a limited number of them are invited to conduct due diligence (with documents normally posted in a virtual or physical data room) and attend management presentations. Vendor due diligence reports are fairly standard. Generally, during this phase, buyers receive a first draft of the purchase agreement prepared by seller's counsel. At the end of this phase buyers submit their bid, together with a mark-up of the purchase agreement and other related documents. One buyer is then selected to conduct final negotiations with the seller and finally sign the definitive agreement.

Occasionally, businesses are sold in private transactions. This is much preferred by private equity houses because of the lack of competition and because of the higher level of information that they typically receive from sellers. Sellers have been willing to follow this path (instead of an auction) where there is a very committed buyer who could offer certainty of closing within a relatively short time frame.

Public to private transactions are not uncommon but are more complex to execute compared to deals involving private companies.

Italian public to private transactions are regulated by the Consolidated Securities Act of 1998 and numerous Consob regulations. These transactions are generally structured as multi-step acquisitions in which the buyer:

In order to take the target company private, the offer is generally followed by a mandatory buyout of the remaining shares if the buyer is able to acquire 90% or more of the voting shares (and the subsequent exercise of a squeeze-out right over the minority shareholders of the target company if the buyer acquires 95% or more of the target shares).

Alternatively, assuming the buyer then holds a sufficient number of target company voting shares to approve it, the second end of the transaction can be structured as a forward merger of the target company with and into the buyer, with the latter remaining as the surviving entity. A merger triggers withdrawal rights for the target company's dissenting shareholders.

Principal documentation

The principal document between the seller and the buyer is typically the sale and purchase agreement. In a cross-border transaction the parties usually have a master purchase agreement and local transfer instruments that are designed to make the transfer effective in each local jurisdiction in accordance with applicable legal requirements.

The buyer and the incumbent management team, in connection with the funding of the acquisition entity, usually enter into investment agreements, shareholders' agreements and employment agreements. Depending on the structure of the financing, the buyer may also be required to grant the acquisition entity one or more loans in addition to equity capital contributions.

Private equity firms usually provide the seller with an equity commitment letter, under which the fund commits to provide the equity capital to the acquisition entity subject to certain conditions set out in the acquisition agreement. It is not uncommon for the seller to seek the status of third party beneficiary under the equity commitment letter for it to have a right against the fund if the latter fails to provide the equity capital at closing. The parties, however, enjoy broad powers to shape the rights of recourse against the fund in favour of the seller.

Bank financing is almost invariably present in any private equity transaction (see Question 23).

Buyer protection

In the highly competitive pre-crisis environment, the offering of very limited contractual protection to buyers was common market practice. This required buyers to conduct deeper due diligence investigations to compensate for their low contractual protections, which often did not extend beyond:

Locked-box mechanisms entail both:

Locked-box mechanisms are still widely used in secondary buyouts and are favoured by sellers as they provide price certainty.

A structural alternative to a locked-box mechanism is the use of an estimated equity price and a post-closing price adjustment. Typical price adjustment factors include net financial debt and working capital. This structure is generally used in the case of a corporate carveout or similar transaction, in which standalone accounts are missing. Purchase price adjustment clauses are heavily negotiated between the parties.

Although cash is the default type of consideration, other forms of consideration that can be used to bridge the gap between seller's price expectations and buyer's available resources or business valuation include vendor financing or contingent purchase price payments (earnouts or similar mechanisms).

Buyers seek maximum flexibility and sellers seek deal certainty in negotiating closing conditions. Therefore, key contract terms related to deal certainty, such as financing conditions, material adverse change provisions and reverse break-up fees, receive significant focus.

Buyers usually expect to receive a full range of representations and warranties covering substantially all the matters regarding the target company and its business. However, in the secondary buyout market, private equity funds generally limit the representations and warranties they are prepared to offer to the buyer to title and the seller's ability to complete the transaction. Similarly, in public to private transactions, bidders proceed with a transaction based only on the due diligence without warranty or indemnity protection (other than those that may be given by controlling selling shareholders).

In situations where sellers are not willing to give representations and warranties concerning the target business (such as in secondary buyout transactions), buyers generally look for warranties from selling managers. Although these warranties have financial and practical limitations, they are generally sought to get disclosure of information.

The warrantor's liability for breach of warranties is usually subject to a number of limitations, which are usually heavily negotiated between the parties. Key limitations are:

Other limitations generally negotiated between the parties include, among other things, whether the buyer had knowledge of the relevant matter or whether other sources of redress (that is, third-party claims or insurance) have been exhausted.

Sometimes, specific known issues (including, for example, pre-closing tax or contingent environmental liabilities) are dealt with through specific indemnities.

Part of the consideration may be put in escrow to cover risks under warranty claims or other specific liabilities. Other forms of buyer's protection include the issuance of bank guarantees or of an M&A insurance policy for the benefit of the acquirer.

The buyer can also be protected by interim covenants, which limit the seller's ability to take certain actions between signing and closing without the buyer's consent. Key areas in this respect are the buyer's control over debt, working capital, capital expenditures, litigation, personnel and M&A transactions involving the target company.

Managers of a portfolio company who take a position as director owe fiduciary duties to the company. In general terms, directors must act in the best interests of the company. The interests of the company are normally equated with the long-term interests of its shareholders.

While the law does not prohibit directors from being involved in, or soliciting an, MBO, they must act in good faith and in a manner that avoids conflicts of interests or misuse of fiduciary powers. Directors have a statutory duty to declare at a directors' meeting the nature of any interest that they may have in any contract, or proposed contract, with the company. Directors must therefore inform the competent body of the company when they expect to approach potential investors in relation to an MBO.

Typical terms of employment in individual service contracts and the shareholders' agreement include:

Managers are commonly incentivised in their capacity as shareholders (by good leaver or bad leaver provisions) or other employment instruments giving share options or other incentive securities. The bye-laws or the shareholders' agreement may give additional protection to the investor by:

A private equity fund controls the majority of the acquisition vehicle's equity in a typical single sponsor transaction. Therefore, private equity funds secure rights to nominate and elect directors and they do so with a view to protecting their interest in both the acquisition vehicle and the target company.

However, once appointed, the nominee is legally required to ignore the underlying rationale for the appointment and to promote the company's interests at the expense of those of the fund. The private equity fund can remove directors at any time, although if the removal is without cause, then directors are entitled to recover damages, which are usually determined as an amount equal to the remaining compensation that they would have received if they had held the office until its natural expiration.

It is common for the private equity fund and the other equity holders (including managers) to enter into a shareholders' agreement giving the fund a right to nominate a majority of the company's directors and appropriate voting provisions to ensure that the sponsor controls a board majority. If the sponsor invites minority investors to participate in the transaction, shareholders' agreements may offer the minority shareholders exit rights and veto rights over certain fundamental matters. However, the sponsor typically exerts control over exit transactions by reserving drag-along rights, rights to request an initial public offering (IPO) of the shares of the company and other similar rights.

Debt financing

In general, 2010 saw an increased use of leverage by private equity funds. The average net debt used to finance deals grew more than 50%, reaching EUR25 million, against EUR13 million in 2009. On average, in 2010, the net debt paid was 2.2 times the target's earnings before interest, tax, depreciation and amortisation (EBITDA), higher than 1.9 multiple reached in 2009, but still below the pre-crisis value of 4.5 times EBITDA experienced in 2007. In addition, the debt-to-equity ratio in buyout measures 1:3 compared to 1:0 in 2009 is expected to significantly increase in the future depending on the economic downturn and on the forms of debt financing used in private equity.

In this respect, the principal form of debt finance continues to be senior debt, which is provided by banks and institutional lenders. Senior debt is generally guaranteed by all companies of the group (including the target company) and is secured over all of their assets, subject to certain limitations. Senior debt has a shorter maturity compared to the other debt finance and is typically amortising. The facilities generally provided in a senior finance package include a:

The senior loan facility agreement typically contains detailed provisions designed to protect the lenders' investment (see Question 24, Contractual and structural mechanisms).

Junior debt is used, particularly in larger transactions, to increase the total amount of debt available and to bridge the gap with the equity package. Junior debt generally takes the form of:

All junior debt ranks behind the senior debt in terms of priority of repayment.

The seller can also provide a source of finance, typically in the form of deferred consideration or an earn-out.

Typically, acquisition finance is funded by a bridge facility provided by the senior lenders, which is taken out sometime after the funding of the senior term facility following a merger of the target (which then becomes the borrower) or through a refinancing (debt pushdown). Most often, the senior debt is made available to the acquisition vehicle (in the form of a bridge loan) to finance the acquisition, and to the target company to refinance its existing debt and for working capital purposes.

Mezzanine debt ranks behind senior debt and, as a result, has a higher interest rate. Typically, there is just one borrower, the acquisition vehicle. It generally matures later than the last tranche of the senior debt and is repayable in one bullet instalment. The margin generally includes a PIK element in addition to a cash element. Financial covenants are present but typically contain more headroom. It is fairly common for warrants giving the right to subscribe for shares in the borrower at a predetermined price to be issued to the mezzanine lender as part of the package.

All historical data in Question 23 is from Il mercato italiano del Private Equity e del Venture Capital nel 2010 published by the AIFI and from Private Equity Monitor Italia 2010 published by PEM Observatory.

Lender protection

Security

Bridge acquisition facilities are usually secured by a pledge over the shares of the acquisition vehicle and the shares of the target group, and/or by an assignment by way of security or a pledge of the receivables arising under the acquisition documents or under any shareholder loan documents.

Following the debt pushdown, the senior debt security package typically includes full asset security from each company in the target group (including the acquisition vehicle), sometimes subject to a materiality threshold. Although the legislative decree no.142 in 2008 has introduced the possibility to give financial assistance (subject to certain limitations and compliance with certain requirements (see Question 25)), significant legal and tax constraints still apply to the giving of upstream or cross guarantees and related security.

Contractual and structural mechanisms

Typically, structural subordination is effected by using more than one special purpose vehicle.

The senior debt is typically at the top of the capital structure and is not subordinated to any other type of finance. The acquisition facility is first borrowed directly by the acquisition vehicle and then pushed down to the level of the target company after the acquisition. Other senior facilities are generally made available to the target company after the acquisition.

Typically, senior creditors are party to an inter-creditor agreement with the other finance providers. This agreement governs matters such as:

The senior loan facility agreement typically contains detailed provisions designed to protect the lenders' investment. These mechanisms are generally determined on a case-to-case basis but such provisions almost invariably include:

Financial assistance

Rules

The giving of financial assistance by a company, through either granting of loans or providing securities or guarantees, for the purposes of the acquisition or subscription of shares in itself is prohibited. In addition, a company is prevented from accepting its own shares as security or guarantee, even through a fiduciary or any other entity.

Exemptions

The Italian Civil Code now permits the giving of financial assistance when it has been approved by special resolution of the extraordinary shareholders' meeting of the company. There are two limitations on this to protect the interests of creditors:

Other exemptions exist which are intended to allow companies to support employees' share schemes and other share acquisitions by employees.

In a leveraged buyout (LBO) before completion, the directors of the acquisition vehicle and target must consider the financial resources that are necessary to repay the debt incurred as a result of the acquisition and there are specified procedural requirements for this. However, this does not exclude the applicability of the financial assistance rules.

Insolvent liquidation

The order of priority on insolvent liquidation is regulated by the Italian Bankruptcy Act. Creditors have priority over equity holders, which are regarded by the law as residual claimants. This may apply to shareholders' loans, which may be subject to equitable subordination.

As a general principle, secured creditors holding valid fixed charges over specific assets of a company are satisfied to the exclusion of all other creditors, including secured creditors of a lower rank (for example, first degree mortgage over second degree mortgage).

Certain other creditors enjoy the status of preferred creditors (such as employees with outstanding wages). The Italian Civil Code gives very detailed rules regulating priority conflicts between secured and preferred creditors.

Creditors can agree to contractual subordination by signing subordination or other inter-creditor agreements. Inter-creditor agreements also typically prohibit any payments to shareholders by way of dividends or through redemption of shares until full repayment of senior creditors.

Equity appreciation

Debt holders can achieve equity appreciation through conversion features on terms which provide for the investor to be able to convert its debt security into a share in the borrower at a later date.

A debt instrument with an attached warrant is similar to a convertible bond. The warrant gives the holder the option to subscribe to shares. The debt-plus-warrant structure differs from convertible bonds in that exercise of the warrant does not bring the debt instrument to an end, whereas the debt instrument disappears when a conversion right is exercised.

The characteristic shared by convertible bonds and warrants, and which makes them both hybrid securities, is that they offer their holder the opportunity to participate in capital growth, thereby requiring the portfolio company to set aside a portion of its share capital to service such holders.

A debt holder can receive newly issued shares of the company in exchange for a waiver of its outstanding claim against the company, subject to passing a specific resolution of the extraordinary shareholders' meeting, and other procedural requirements. The terms of this transaction may be part of investment agreements and in many cases are conditional on various circumstances.

Portfolio company management

Common management incentives, which may be combined, include:

There are no tax reliefs or incentives available to portfolio company managers investing in their company.

There are no restrictions other than those provided for in the fund rules.

Exit strategies

IPO, sale (trade sale or secondary buyout) and recapitalisations are all typical forms of a successful exit.

IPO

Historically, the IPO has been a successful form of exit for private equity funds. The major benefit of an IPO is that the private equity fund does not need to subscribe to burdensome warranties or absorb price contingencies, which can happen in a trade sale. Other advantages can include a higher valuation (depending on the market), prestige and access to more capital and liquidity for the longer-term shareholders (including managers). The downside is that the process is longer, relatively costly and may not allow a full exit by the private equity house. The exit through an IPO is typically delayed by lock-up periods, usually ranging from six to 12 months.

Trade sale

Trade sales, either to a trade buyer or to another private equity house (usually with the management reinvesting), are generally structured as a sale of 100% of the shares of the acquisition holding company. Trade sales usually offer the advantages of deal speed and closing certainty while minimising continuing exposure to liability. Sales by private equity houses generally take the form of an auction.

Dual tracking

Sometimes, especially in the case of larger companies with well-recognised brands and strong management teams, private equity houses pursue an exit through an IPO in parallel with a trade sale until they choose which route will achieve the highest value.

Recapitalisations

Typically, in a leveraged recapitalisation the portfolio company borrows debt and uses the proceeds to pay a special dividend to the private equity house. Financial assistance issues need to be carefully addressed in this type of transaction (see Question 25).

Private equity sponsors typically exit from an unsuccessful portfolio company due to financial distress, unless the management is willing to try to acquire the company and attempt a turnaround. Private equity sponsors usually enter into negotiations with financial investors specialising in turnaround situations and restructuring.

Some forms of pre-packaged bankruptcy have also become very attractive in 2009 because of the number of healthy companies that were unable to refinance pending debt maturities in what remains a closed debt market. Other techniques used by private equity funds to avoid the costs and value loss of bankruptcy are the restructuring plans provided for by the Italian bankruptcy Act and other forms of compositions with creditors.

*This chapter was written in collaboration with Massimo Antonini (Tax), Luca Bonetti (Banking) and Vincenzo Troiano (Regulatory).