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Leveraged buy-outs in Italy

The leveraged buy-out is increasing in importance for the private equity industry in Italy. There are, however, various legal issues for investors to be aware of within the Italian leveraged buy-out structure, as this overview from Zini & Associates shows.

Over the last few years leveraged buyout transactions (LBOs) in Italy have been increasing in both number and size, notwithstanding court decisions questioning their legality. This article outlines the main legal issues arising in an LBO, taking also into consideration the provisions of the new corporate law reform (Law n. 366 1 October, 2001, Parliament delegates to the government the reform of the corporate law).
 
The main features of an LBO are:
 
(a) a group of buyers incorporates a vehicle company (‘Newco') in order to purchase the target company (‘the Target');

(b) Newco, aided by bridge financing that is provided by lending institutions, acquires all the shares of the Target;

(c) Newco and the Target merge;

(d) after the merger, the bridge financing is replaced by medium or long term financing secured on the assets of the merged company.

Newco generally takes the form of an S.r.l. (società a responsabilità limitata) that is, a limited liability company. The main difference between an S.r.l. and an S.p.A. (società per azioni), the better known form, is that an S.r.l. has quotas rather than shares and smaller minimum capital. However, there are other formal differences which make an S.r.l. a more flexible instrument for this stage of the LBO process.

In the classical LBO Newco's capital is subscribed to by private, external investors including financial institutions while, in the so-called management buyout, the Target's equity is subscribed to by key personnel.

The purpose of an LBO is to repay the debt incurred by the Target, after the acquisition, through the exploitation of the financial resources of the Target, generally utilizing sums drawn from the Target's profits or through the sale of goods no longer deemed essential by the Target.

The operation aims to ‘shift' onto the Target the debt incurred for the acquisition, by using the leverage (the ratio between the total debt and owner's equity of a company), taking also into consideration the cash flow forecast of the companies involved and the passive interest connected to the debt.

Generally, immediately after the purchase, Newco and the Target merge.

In practice, both companies have to resolve in general meeting upon the merger, on the base of an up to date balance sheet and state of affairs vouched for by directors.

The minutes of extraordinary general meetings of both companies must then be lodged with the Courts where the companies are incorporated. The order of the Court will give rise to the ultimate merger. After the Court has made its order there is a statutory period of three months during which the creditors of both companies can oppose the merger. The statutory period can be reduced in certain cases, depending on certain circumstances. If creditors oppose the merger, it is suspended until the Court has given its judgement, unless a bank guarantee is provided to secure payment of the opposing creditors. Assuming no opposition, the companies can then proceed with the merger by way of a notarial deed lodged at Court; this completes the process. The company which results from the merger enjoys all the rights and is subject to all the obligations of the two companies which existed prior to it. This means that, post-merger, there is now one company with all the assets of the Target and all the debts of Newco.

The merger gives rise to a registration tax of 1 per cent on the net worth of the company absorbed in the process of the merger; in the posited case, that will be the net value of the Target. As matters presently stand, a fiscal advantage is presented b the ability to use the difference between the book value of Target's assets prior to the merger and the price actually paid by Newco for  the purchase of Target's  shares either to revalue the assets of the merged company or to write by way of goodwill. In the first case, while the revaluation of the assets (provided it is no later than the price/value difference) does not give rise to any taxable capital gains, the merged company will be able to depreciate higher values, so reducing its taxable income: moreover, if the assets of the merged company are subsequently sold following revaluation, the relevant capital gains will be reduced, with consequent tax savings. In the second case, the value of goodwill can be entirely depreciated in five years.

The particular nature of mergers in Italian law provides, at the moment, legal issues in structuring an LBO in Italy represented by its compliance or not to the provision of the paragraph 1 of the article 2358 Italian Civil Code (c.c.) that provides ‘A company may neither grant loans nor provide guarantees for the purchase or subscription of its own shares'. Moreover: ‘A company may not (…) accept its own shares as guarantees'. This prohibition on providing ‘financial assistance' to a possible purchaser has been broadly construed by courts analyzing these issues; in fact, such financial assistance includes loans, payment deferrals, lines of credit, and so on.

Although a number of cases have dealt with LBOs, the Italian courts have for the most part failed to closely address the legal issues concerning these transactions. For example, in a 1999 decision concerning an LBO transaction implemented through a merger, the Court of Milan maintained that in the absence of a solid business reason for the merger itself, such a transaction must be considered illegal, as it violates the prohibition set forth by article 2358 c.c.. Nevertheless, such a decision, which constitutes an important precedent in LBO jurisprudence, did not identify specific reasons as to why the transaction was to be considered illegal, thereby providing little guidance for future cases on the same issues.

It should be noted that the prohibition set forth by article 2358 c.c. is imposed on the directors of the Target, who should refrain from providing financial assistance for the acquisition of shares of their own company. On this basis, some authors conclude that the provisions of article 2358 c.c. do not apply to the purchaser of the Target, which is not under an obligation to repay the acquisition debt without using the Target's assets.

Today, legal issues are dealt by Law n. 366 of 1 October 2001, which provides the exception of the merger LBO within the scope of the article 2358 c.c.. Article 7, letter (d), of the Law n. 366 1 October 2001 in fact expressly provides that the reform of the merger would be inspired by the directive principle according to which ‘the merger between companies, where a company has incurred debt in order to acquire the control of an other, does not include the prohibition to purchase or subscribe its own shares, ex articles 2357 and 2357 quarter c.c., and the prohibition to grant loans or to provide guarantees in order to purchase or subscribe to its own shares, ex article 2358 c.c.'.

At the moment, Law n. 366 1 October 2001 is under discussion by the government commissions and will probably come into force on 1 January 2003, following to the Parliament's approval. 

In conclusion, and in the light of the corporate law reform, there seems no reason why LBOs, albeit with considerably less leverage than has been seen in the USA, should not be an increasingly common event on the Italian corporate scene. Historically, medium-sized Italian companies, frequently in closed or family ownership, have been to a substantial extent self-financing and are not generally highly geared. The continued strong performance of Italian industrial and commercial companies in many sectors gives a promise of strong cash flows for the future to support the LBO buyer. In the longer term there is the likelihood that flotation on the stock exchange will be sought by more Italian companies.

Copyright © 2003 Zini & Associates

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