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INTERPRETING THE M&A BLACK BOX BY THINKING OUTSIDE THE BOX

Douglas Cumming and Simona Zambelli

Introduction

The main purpose of this chapter is to provide policy makers with new insights to better evaluate the current worldwide debate on debt merger acquisitions, as well as shed some light on the perils of stringent financial bans on these types of transactions. Debt merger acquisitions (M&A) represent deals that are financed primarily with debt and are accomplished with a merger between the target and the investee company. These types of deals are very common in the European private equity (PE) industry and play an important role in reinforcing the market for corporate control, as well as in reducing agency costs by reorganizing the ownership structure of target companies and guaranteeing a better alignment of stakeholders’ interests.

Debt M&A, also known as leveraged buyouts (LBO), have been at the center of an intensive worldwide debate and criticism since the late 1990s, especially after the 2007 financial crisis. PE funds have been repeatedly criticized for their lack of regulation and insufficient disclosure (see, e.g., Ferran, 2007; Jelic & Wright, 2011). In the US, critics have also asserted that LBOs should be prohibited given their potential detrimental effects on the target’s assets due to the high amount of debt involved in the transaction (Stein, 2006). PE investors financing LBOs have even been labeled as “locusts” (Petitt, 2014; The Wall Street Journal, 2005) or asset strippers (e.g., The Guardian, 2007) who cut jobs and contribute to the weakening of the acquired companies by depriving them of their strategic assets and increasing their risk of bankruptcy.¹ In line with this view, legal scholars (doctrine) and courts (jurisprudence), as well as European policy makers (e.g., Financial Service Authority, 2006) have strongly criticized LBOs emphasizing the need for a more restrictive and harmonized regulatory environment (Cumming & Johan, 2007).² The Italian Supreme Court even deemed the LBO scheme illegal and prohibited its adoption within the domestic market (Supreme Court Decision 5503/2000).

The criticism against LBOs intensified after 2007 and an increasing call for more stringent regulations and bans on LBO transactions was repeatedly echoed by the media, unions, and politicians around the world (see, e.g., The Economist, 2016). As an aftermath of the crisis, a wave of new regulatory proposals and legal reforms of PE and other alternative investment funds (such as hedge funds) was introduced with the purpose of guaranteeing more financial stability and higher investor protection (Avgouleas, 2009; Davidoff & Zaring, 522009; Ferran, 2011; Claessens & Kodres, 2014; De Fontenay, 2014).³ It is worth noting that the growing regulatory attention on PE funds was not due to the fact that they caused the crisis (see, e.g., Allen & Carletti, 2010). The crisis was instead a pretext to regulate PE funds more heavily, as ironically commented by The Economist (2009) “When a fight breaks out in a bar, you don’t hit the man who started it. You clobber the person you don’t like instead.”⁴

Understanding the new current legal environment regulating M&A, as well as the controversial issues underlying PE transactions and other alternative investments is crucial for PE investors, especially when evaluating the opportunity to carry out cross-border M&A. As shown in the law and finance literature, the legal environment affects investors’ behavior (e.g., Lerner & Schoar, 2005; Cumming et al., 2006; Kaplan et al., 2007; Bottazzi et al., 2009; Cumming & Johan, 2013; Cumming & Zambelli, 2017), as well as transactional risk (Cumming & Zambelli, 2010), and fund performance (Cumming & Zambelli, 2013).

Despite the growing literature on the positive impact of PE transactions on investee performance (e.g., Cumming et al., 2007; Nikoskelainen & Wright, 2007; Renneboog, 2007; Cao & Lerner, 2009; Harris et al., 2014, 2015; Liu, 2014; Buchner et al., 2016; Gompers et al., 2016; Hooke et al., 2016),⁵ an international concern is whether PE transactions should be more heavily regulated in order to better protect the assets of target firms and their stakeholders. In the economic literature little empirical attention is dedicated to the impact of PE regulatory reforms, and the majority of the available studies on this matter are essentially industry reports or legal reviews (e.g., Enriques, 2002; Giannino, 2006; Enriques & Volpin, 2007; Ferran, 2007, 2011; Heed, 2010; EVCA, 2015; Invest Europe, 2017).

Notwithstanding the ongoing regulatory and media attention devoted to the PE industry, there continues to exist a substantial confusion about the intrinsic characteristics of LBOs, especially in terms of how they can increase the value of target companies (De Fontenay, 2014), and how legal reforms may shape investor behavior towards the direction desired by policy makers. This chapter aims at filling this gap by showing the results of recent empirical studies on the impact of corporate governance reforms in the context of PE financing in Italy, a country in which PE transactions were previously prohibited and thereafter legalized. In this perspective, the Italian PE market offers a unique and timely experimental example to better evaluate the efficacy of stringent regulatory restrictions on LBO deals.

PE investors are characterized by their active involvement in their investee companies (see, e.g., Cumming & Johan, 2013), and such fund involvement is crucial to maximize the value added of their investments, both in terms of fund returns and investee performance (e.g., Jelic & Wright, 2011; Bonini et al., 2012; Borel & Heger, 2014; Gao, 2014). The introduction of extreme regulations or bans may have detrimental effects on target companies as they may reduce the quantity and quality of fund involvement and this, in turn, may negatively affect the entire investment cycle (Cumming & Dai, 2011), the governance of the target companies (Cumming & Zambelli, 2010), as well as the due diligence process (Cumming & Zambelli, 2017), and the potential value-added that PE investors could generate in their portfolio firms (see, e.g., Suchard, 2009; Hamdouni, 2011; Cumming & Zambelli, 2013).

The remainder of this chapter is organized as follows. The next section describes the financial structure of LBOs by discussing the typical LBO investment process and highlighting what is inside the LBO black box. The following section sheds light on the previous and ongoing criticism raised against LBOs (“dark side”) and discusses the reasons why LBOs were deemed illegal in Italy. Also, this section has the purpose of better clarifying the legal status of LBOs by describing the new corporate governance reform issued in Italy. Furthermore, the section highlights unresolved issues associated with the legitimacy of LBOs, as 53well as important challenges and criticism raised by the tax authorities. Understanding the previous and current legal issues surrounding LBOs is crucial for international investors in order to allow them to better evaluate their transaction risk. Thereafter we discuss the economic impact of the new LBO reforms in terms of investor behavior, due diligence, and investee performance. The last section provides concluding remarks.

Financial structure of LBOs: opening the black box

For the purpose of this study, PE financing refers to equity investments in existing and developed companies, and LBOs are the acquisition of a company (called target) by another company (called newco) accomplished with a large amount of debt relative to the asset value of the acquired company (typically the debt represents the 60–70% of target asset value; see, e.g., Axelson et al., 2009a, 2009b; Siegel et al., 2011; Baldi, 2015).

Buyouts have always played a dominant role within the Italian PE market. In 2015, for example, the total amount invested in buyouts in Italy was €3,255 million, representing 70.5% of the entire PE industry (Figure 4.1).

The main criticism surrounding LBO transactions is connected to the interpretation of their financial structure and economic results. The most criticized result of an LBO is the shifting of the financial burdens from the purchaser (newco) to the acquired company (target). In order to better understand the criticism against LBO transactions, in the following sub-section we focus on the steps that are typically followed by PE investors to accomplish LBOs. We also focus on the criticism raised by legal scholars and courts within the Italian PE industry, whose transactions experienced relevant and unique legal changes, from prohibition to legalization.

LBO investment process

The structure of an LBO may be quite complex, and the entire LBO process involves a number of different steps and actors (Baldi, 2015), as summarized below and shown in Figure 4.2.

Phase 1: Establishment of a new company (vehicle). The first step towards accomplishing an LBO is represented by the incorporation of a new company (holding company or 54newco, which is created with the sole purpose of acquiring a specific target firm. The newco, typically, is not an active producing company, but it serves as a special purpose vehicle (SPV) to accomplish the transaction and generally takes the form of a limited liability company. The equity necessary to establish the newco is often supplied by PE investors, who may co-invest either with the management of the target (MBO) or with an outside management team (MBI).

Figure 4.1      Buyouts in 2015

This figure shows the relative proportions of buyouts carried out in Italy in 2015 relative to the total amount invested in the entire PE industry (numbers reflect percentages)

Source: Elaboration from AIFI Statistics Reports (2015).

Figure 4.2      Buyout structure: steps, effects, and implications

This figure represents the typical steps involved in the buyout process, from the establishment of the newco to the merger between the newco and the target.

Source: Authors.

Phase 2: The acquisition of a loan. One characteristic of LBOs is that these types of transactions occur with the adoption of a relatively high amount of debt (60–70%) with respect to the asset value of the target company. In this phase, the debt acquired by the newco typically takes the form of short-term debt (bridge financing) and it will be renegotiated into a longer-term debt once the buyout has been completed.

Another crucial (and highly criticized) characteristic of LBOs is that the debt is arranged and obtained by the newco under the expectation that it will be secured and repaid by the target company with its future cash flows or the sale of its non-strategic assets. As such, the 55expected target’s cash flows, as well as the quantity and quality of the target’s assets, represent a crucial precondition for the accomplishment of LBOs, as they serve as collateral for the debt. Given that in an LBO the target firm bears most of the economic costs related to its acquisition, the success of the entire LBO process depends on the financial and economic conditions of the target, as well as its growth potential. In line with the free cash flow theory applied to buyouts (see, e.g., Jensen, 1986, 1989; Opler & Titman, 1993), an ideal candidate for an LBO acquisition should have a modest level of initial debt, as well as a business plan with sufficiently high expected cash flows in order to prove the feasibility of the entire transaction and the target capacity to effectively repay its debt obligations.

Phase 3: Purchase of the target’s share. LBO transactions usually target mature companies with the purpose of completely restructuring them (see, e.g., Cumming & Johan, 2013). In order to minimize the risk of a dispute with minority shareholders, in a typical LBO the newco acquires the totality (or at least a majority stake) of the target’s shares. After the acquisition, the target’s share will appear on the asset side of the newco balance sheet.

Phase 4: Merger between newco and target. In Italy, the LBO acquisition is typically followed by a merger between the target and the newco. After the merger the bridge financing, originally arranged by the newco, is replaced by a new medium- or long-term debt, secured by the assets of the merged company. The main effect of the merger is the concentration into a new combined entity of all the assets and obligations that previously belonged to the newco and the target.

As a result of the merger, the combined company is left with a higher leverage ratio (debt-to-equity ratio) compared to the one the target company had before the acquisition. In the end, the loan originally obtained by the newco is merged into the target’s liabilities (“debt push down”), and any claims by the newco’s creditors are therefore transferred to the target’s asset.⁶

As summarized in Figure 4.2, two types of mergers exist: forward and reverse. In a forward merger, the target is engulfed into the newco and, as a result, the target legally disappears. As a consequence, the target’s shares previously acquired by the newco are cancelled and substituted with the assets of the target. In a reverse merger, the newco is engulfed into the target and, as such, the newco legally disappears and the target is the sole remaining company. In both cases, the new combined company enjoys all the rights and it is subject to all the obligations that the two prior companies had before. As a result of a reverse merger, the equity participation acquired by the newco for the purchase of the target company will be included inside the target’s assets.⁷

Industry evolution and related legal changes

Table 4.1 shows the evolution of the Italian buyout market from 1988 to 2015, in terms of frequency, average deal size, and number of investors actively involved in the industry. As discussed in Zambelli (2010), both the volume and the value of buyouts carried out in Italy increased sharply over the 1990s. From 2000 until 2006, however, the evolution of buyouts in Italy followed a puzzling zig-zag trend, alternating periods characterized by strong decreases in the buyout frequency (e.g., from 2000 to 2001) with periods characterized by sharp increases in the number of buyouts (e.g., after 2004). One possible explanation for this puzzling trend may be associated with the drastic legal changes experienced by the Italian PE industry, as summarized in Figure 4.3 and discussed in the following sub-sections.

Table 4.1      Buyout market over the 1988–2015 period

LBO criticism and regulatory changes: causes, implications, and unresolved issues

Over the last decades, an intensive debate has emerged about the legitimacy of LBOs, as well as about the necessity of imposing more regulatory restrictions on LBOs in order to better protect the interests of target companies and their stakeholders.

While in Europe the debate intensified after the global financial crises, in Italy the greatest LBO criticism started in the late 1990s. Over the 1990s, in fact, the legitimacy of LBOs was critically challenged by Italian courts and remained uncertain until the issuance of a new corporate governance reform (Legislative Decree 6/2003, effective as of January 1, 2004). The debate on the LBO legitimacy exacerbated in 2000 when a Supreme Court’s 57Decision deemed the LBO scheme illegal and prohibited its adoption within the Italian market (Supreme Court Decision 5503/2000, February 4, 2000).

Figure 4.3      LBO market trend and related regulatory changes (1995–2006)

Figure 4.3 shows the puzzling evolution of the Italian buyout market in relation to the most recent changes in the regulatory environment, especially after 1999.

Source: Zambelli (2008: 64).

In the following sub-sections, we will provide more detailed information on the reasons underlying the LBO criticisms and the accusations of illegality raised against these types of transactions.

LBO criticisms and illegality accusations

As mentioned earlier, over the 1990s and until 2004, the legitimacy of LBOs was uncertain and strongly debated. The Italian case law (jurisprudence) and legal scholars (doctrine) provided contrasting and inconsistent interpretations, which contributed to increasing the uncertainty and risk associated with these types of transactions.⁸

LBOs were accused of involving a lack of transparency and contributing to the weakening of the target firms. LBOs were also accused of being examples of indirect financial assistance provided by the target for the acquisition of its own shares. This type of financial support is against the law and, in particular, is a breach of the financial assistance ban set by European Law, according to which a company cannot grant a loan or provide a guarantee for the acquisition of its own shares. Such a ban was originally introduced in Europe by article 23 of the Second Directive on Corporate Law (Directive 77/91/EC, December 13, 1976) and was applied by each member State in a different way. Some countries, such as the UK and Germany, applied the ban to public companies only and allowed private companies to provide financial assistance for the purposes of share repurchases. Other countries, such as Italy, applied the ban to all companies, public and private.⁹

By looking at the Italian court’s decisions, the core of the criticism against LBOs was focused on the interpretation of the ultimate economic result of these types of deals, often taken for a fraudulent share buyback transaction. In particular, a few legal provisions of the Civil Code were invoked against the legitimacy of LBOs: article 2357, article 2358, and 58article 1344. Article 2357 limits the possibility for a company to acquire its own shares. Article 2358 prohibits a company from providing financial assistance or a guarantee for the acquisition of its own shares. This article aims at protecting the integrity of the company’s assets, to the benefit of its creditors and stakeholders. Given the fact that the debt underlying the LBO transaction is acquired by the newco under the expectation of being repaid by the target and that the target’s assets serve as a guarantee for such debt, LBOs were accused of breaching the financial assistance ban. Article 1344 invalidates any agreement whose ultimate result is to create a situation which is elusive of imperative provisions of the law. Article 1344 was invoked to invalidate the merger agreement between the newco and the target (for more details, see Giannino, 2006; Zambelli, 2008, 2010).

A particular interpretation of the law (hereafter “illegality view”) viewed LBOs as share buyback deals, and interpreted them as financial tools fraudulently adopted by the target to elude the law by allowing the latter to implement a share buyback outside the restrictions imposed by the Italian regulation. From this perspective, LBOs allow the target to: (a) acquire its own shares eluding the restrictions set by article 2357 and (b) provide a guarantee for the loan that was arranged to acquire its own shares, in breach of the financial assistance ban set by article 2358. In application of the “illegality view,” a number of LBOs were invalidated by Italian courts because they were interpreted as being equivalent to an indirect share buyback deal (see Figure 4.4), as well as instances of indirect financial assistance fraudulently provided by the target for the repurchase of its own shares (see Figure 4.5). The newco, in turn, was considered merely an intermediary acting on behalf of the target to help the latter elude the law.

The breach of the financial assistance ban appeared more evident in the cases of LBOs carried out without the merger, as well as in the cases of reverse merger LBOs, as visualized in Figure 4.4 (see Zambelli, 2008 for more details).

Figure 4.4      LBO scheme, interpreted as an indirect share buyback

This figure summarizes the criticism against the LBO scheme which appears to produce the results of a share buyback implemented by the target with the intermediation of the newco, against the limits set by article 2357 of the Civil Code.

Source: Zambelli (2008: 70).

59

Figure 4.5      LBO scheme, interpreted as a breach of the financial assistance ban

This figure summarizes the criticism against LBOs: as a result of the merger, the target assets serve as a guarantee for the loan previously obtained by the newco. This is against the restrictions imposed by article 2358 of the Civil Code and, as such, the effects of the merger may be invalidated by article of the Civil Code.

Source: Zambelli (2008: 71).

Legal scholars and courts also challenged the validity of the merger agreement between the target and the newco. The court’s decisions on this matter, however, were inconsistent and did not offer any clear guidance to investors.¹⁰ Sometimes, the merger was considered a natural way to complete the LBO deal, allowing a concentration of assets between the newco and the target.

Other times, the merger was considered void because it was interpreted as a tool fraudulently adopted to obtain the exact same results that would otherwise be prohibited by the law. Therefore, the merger was invalidated by invoking the content of article 1344 (see Zambelli, 2008 for critical discussions of these draconian interpretations).

Following a different line of reasoning, in 1999 the Court of Milan intervened and suggested a case-by-case assessment approach, according to which LBO transactions should be considered legal if they are supported by sound business reasons aimed at promoting the development of the company with a proper project and a valid industrial plan (“rule of reasons” or “business judgment approach”).¹¹

Notwithstanding the innovativeness of this approach, the decision of the Court of Milan was criticized, because it left the ultimate assessment of the economic reasons underlying LBOs to the discretionary power of judges and did not provide investors with sufficient guidance, nor examples of business reasons that could be considered sufficient to ensure the legality of LBO transactions. Therefore, the legal uncertainty and the associated risk of receiving an illegality declaration by a Court was still very high, despite the new “business judgment” approach introduced by the Court of Milan.

The debate on LBO legitimacy intensified in 2000 when the Supreme Court intervened and reinforced the illegality view of LBOs. The Supreme Court deemed the LBO scheme illegal, interpreting it as a direct breach of the financial assistance ban, and therefore prohibited its adoption within the Italian context (Supreme Court Decision 5503/2000 regarding 60the D’Andria case). From a PE perspective, this decision was quite astonishing, especially because the statements of the Supreme Court applied to all LBOs carried out in Italy, and not merely the case that was judged by the Supreme Court. Considering the dominant role that LBOs have always played within the Italian PE market, the Supreme Court’s decision was strongly criticized by the PE industry and increased the LBO debate, rather than solving it.

The high legal uncertainty surrounding LBO legitimacy raised strong concerns among PE investors, especially in consideration of the relevant criminal consequences that they could receive if a Court were to judge an LBO transaction to be in breach of the financial assistance ban. In fact, in the case of a legal dispute, if an LBO deal was charged with eluding the financial assistance ban, the directors involved in the transaction ran the risk of receiving criminal prosecutions of up to three years in prison (article 2630 of the Civil Code, now abolished by the Legislative Decree 61/2002).

What happened after the Supreme Court’s decision?

By looking at the PE industry evolution subsequent to the Supreme Court’s Decision, it is puzzling to note that LBOs did not disappear from the market despite the prohibition. The Supreme Court’s ban only diminished the LBO frequency, but did not exclude them. These types of deals were carried out anyway, especially in the form of mega deals (over €150 million). Clearly, investors were only willing to run the transaction risk underlying LBOs for relevant deals, in terms of size and expected returns. Furthermore, in order to minimize the risks of receiving an illegitimacy declaration, several LBOs were also implemented with the adoption of complex multi-layered structures, characterized by more than one newco firm, one of which was typically located abroad.¹² As summarized in Zambelli (2010), a first holding company (newco 1) was typically incorporated abroad with the purpose of providing the equity capital to set up a second holding firm, located in Italy (newco 2). Newco 2 was established in Italy with the purpose of acquiring the shares of an Italian target company. From a financing point of view, newco 1 required a first loan to complete the acquisition of newco 2. Thereafter, the loan was indirectly transferred or pushed down to newco 2, either in the form of a high share premium or through a non-interest bearing loan (see Figure 4.6). Following the acquisition, newco 2 and the target would merge. Once the merger procedure was accomplished, the share premium (or the non-interest bearing loan) was paid back to newco 1 through a loan agreement between newco 2 and newco 1.¹³ These complex structures were severely criticized by the Italian Tax Authority, which continued to challenge the legality of LBOs until 2016 (see Italian Tax Authority, 2016).

By the end of 2001, the Italian Parliament intervened and issued a Bill of Law (Bill of Law 366, October 2001) announcing its intention to overrule the Supreme Court’s decision and legalize LBOs. With this Bill, in fact, Parliament assigned the Government the task of changing the entire corporate law, as well as introducing a safer and more precise legal harbor for LBOs (article 7, letter d).¹⁴ This Bill did not, however, have an immediate efficacy in Italy. It was merely an enabling act through which the Parliament assigned the Government the task of issuing one or more legislative decrees aimed at reforming the entire Italian corporate governance law according to a set of guidelines, principles, and conditions. Furthermore, there was no certainty of when and how the new reform would be issued. Despite the uncertainty regarding the timing of the new reform, this Bill provided investors with some hope of a more favorable legal harbor for LBOs. Thereafter, in 2002, a new criminal law became effective and new criminal prosecutions were introduced with a potential 61applicability to LBOs (Legislative Decree 61/2002). This Decree increased the confusion and legal uncertainty among buyout investors (for more details, see Zambelli, 2010).

Figure 4.6      LBOs structured as multi-layered deals

This figure shows the typical structure of LBO deals over the period in which their legitimacy was uncertain and challenged by the courts (illegality period). Over the illegality period LBOs were carried out anyway, mainly in the form of multi-layered deals, with more than one newco firm, one of which was typically located abroad.

Source: Zambelli (2008: 73).

In 2003, a new corporate governance reform was introduced and LBOs were legalized subject to a number of specific conditions (Legislative Decree number 6/2003). This reform became effective as of January 1, 2004 (hereafter “the 2004 reform”). With this reform, the Italian Government introduced a new provision (article 2501-bis of the Civil Code) aimed at better clarifying the legal status of LBOs, as well as specifying a number of requirements to ensure the legality of LBO transactions (contingent legalization). These requirements focus mainly on information disclosure, fair deal certification, business plan feasibility, and financial plan reasonableness (for more details on the specific requirements set by article 2501-bis, see, e.g., Giannino, 2006; Zambelli, 2008). Contrary to what has occurred in the past, with the 2004 reform the burden of proof is now reversed: if the conditions set by the new law are fulfilled, LBOs should be considered legal, unless proven otherwise.

Unresolved issues and tax challenges

The 2004 reform legalizes only LBOs that are accomplished with a merger between the newco and the target (merger LBOs).¹⁵ The legitimacy of LBOs accomplished without a merger continues to remain uncertain, as well as the admissibility of LBOs that do not follow the specific procedure and conditions outlined by article 2501-bis. Reverse merger LBOs may still raise concerns: in these cases, in fact, breaches of the financial assistance ban may appear more evident in the eyes of a judge. The debate remains open also with reference to the legal consequences and sanctions applied to the directors involved in an LBO deal in case of bankruptcy of the target (for details see Zambelli, 2010).

Notwithstanding the 2004 LBO reform, LBOs remained highly criticized from a fiscal point of view. In particular, a decision by the Supreme Court (Tribunal Section, 24930, 62November 25, 2011) and a number of Tax Authority interpretations (e.g., Circular 19E/2009) reopened the debate on the legitimacy of LBOs. Since the late 2000s, the Italian Tax Authority has severely challenged LBOs because they are viewed as fraudulent tools implemented by PE investors to elude the fiscal law, as well as to evade taxes.¹⁶ The Italian Tax Authority has viewed all LBO transactions with great skepticism, especially the cross-border buyouts implemented with a multi-layered structure, and repeatedly contested the deductibility of the interest expenses connected to the loan underlying these types of deals. In some cases, the Italian Tax Authority has highlighted a lack of direct pertinence between the debt arranged by the newco and the business activity of the target and, as such, the Authority denied the deductibility of the related interest expenses.¹⁷

In other cases, the Tax Authority has not contested the lack of pertinence between the debt and the business activity of the target, but challenged the merger between the newco and the target, emphasizing the tax elusion result derived from the merger. In the view of the Tax Authority, in fact, the result of the merger is to transfer the liabilities of the newco onto the target’s balance sheet (“debt push down”) and, in doing so, the merger helps the newly combined company reduce the taxable income and evade taxes. This line of thought was especially applied in the cases of cross-border multi-layered deals, characterized by more than one controlling company (newco), one of which was located abroad (newco 1) and the other located in Italy (newco 2). In these circumstances, once the merger between newco 2 and the Italian target company was accomplished, the Tax Authority challenged the LBOs by applying the “transfer price rule” (set by article 110 TUIR) and allocated to the new Italian merged entity a higher taxable revenue, proportionately to the amount of debt pushed down to the target. Paradoxically, the Italian Tax Authority applied a tax on a debt (the loan underlying the LBO transaction), by interpreting such loan as a revenue that the newco could receive thanks to the service of financial assistance provided by the target for its own acquisition (Capizzi et al., 2017). This interpretation adopted by the Italian Tax Authority was inconsistent with the OCSE Guide Lines, according to which the financing costs must be allocated to the party that used the debt (see Grimaldi, 2014).

These draconian interpretations of LBOs by the Italian Tax Authority led to a great deal of criticism especially among PE investors who had to bear the costs of higher taxes and sanctions, even if they were following the 2004 LBO reforms. The public pressure by the PE industry forced the Italian Tax Authority to reconsider the essence of LBOs. Recently, the Tax Authority issued a new Circular Letter (6/E, March 30, 2016)¹⁸ providing important clarifications on merger LBOs and admitting the deductibility of the interest payments connected to these types of transactions. The debate on LBO legitimacy is now closed and the Tax Authority has conformed to the 2004 reform.

Despite the unresolved issues highlighted here, the 2004 reform represents an important turning point for the Italian PE industry, as well as a unique example of contingent legalization of LBOs that could guide other policy makers around the world. As it will be explained in the following section, this reform has contributed positively to accelerating the development of both the Italian PE industry and its target firms.

Impact of the LBO legalization and policy implications

This section discusses the economic impact of the 2004 LBO reform on target firms and PE investor behavior.

In the absence of detailed public information on buyout deals, we carried out a three-stage survey of Italian PE funds who invested in Italy during 1999–2006 and exited their target 63firms between 2000 and 2013. Our data includes the vast majority (84%) of the buyout funds active in Italy.¹⁹ We also performed a number of survey improvements by collecting further information from different public sources (e.g., Datastream by Thomson Corporation, Italian Venture Capital Association, Private Equity Monitor or PEM^® database, investment reports, and PE fund websites) in order to double check, eventually correct and integrate the information obtained with the survey procedure, as well as to collect other relevant control variables (e.g., market returns, industry market to book values, capital under management, other fund characteristics, and balance sheets of target companies).

Our ultimate dataset comprises unique and detailed information on 178 target firms and their performance, actual contractual provisions and control rights included in the PE acquisition deal, as well as information on due diligence and screening criteria of target firms (see Cumming & Zambelli, 2017). In particular, our dataset provides information on the entire PE investment cycle, and is summarized as follows:

•     Amount invested, investment year, transaction type, and deal structure;

•     Selection criteria, due diligence, and methods of valuation of the target;

•     Sources of finance used to accomplish the purchase of the target;

•     Board rights and other control rights held by investors;

•     Investor exit expectations;

•     Exit routes and related fund returns;

•     Performance of the target firms.

In the following sub-section, we will discuss the main results emerging from our empirical tests with reference to the impact of the 2004 LBO reforms. In particular, in the following section, we will analyze the impact of LBO regulation on the investors’ behavior, deal structure, governance of target firms, firm performance, and due diligence. In order to better evaluate the economic impact of the LBO reform, we divided the regulatory changes into three main periods, metaphorically labeled as: Dark period (or period of illegality); Hope period (or period in which the Parliament announced its intention to legalize LBOs); and Sun period (or period of legality). The three sub-periods are also summarized below in Figure 4.7 (for more details, see Cumming and Zambelli, 2010; Zambelli, 2010).

Figure 4.7      The three sub-periods of LBO regulation: Dark, Hope, and Sun

Figure 4.7 defines the characteristics of the three sub-periods (Dark, Hope, and Sun) according to the main changes experienced by the Italian regulatory environment.

Source: Cumming and Zambelli (2010).

64The impact of the LBO legalization on fund involvement, due diligence, and firm performance

In this section, we discuss the main results underlying the studies of Cumming and Zambelli (2010, 2013, 2017).²⁰

In the first of three papers, Cumming and Zambelli (2010) empirically examined the effects of LBO regulations on the structure of LBO transactions. Cumming and Zambelli show that even though LBOs were deemed to be illegal, they were not eliminated from the market. LBOs still existed, albeit they were less common than during periods of legality. LBOs in the period of illegality were more inefficiently structured, since the managerial focus was on evading illegality regulations. Specifically, during the period of illegality, LBOs were characterized with PE fund investors only having a minority of the board seats, fewer control rights, and smaller equity ownership percentages, relative to LBOs in the period of legality. PE fund managers screened target companies for their fit (“agreeableness”) with the target firm management, unlike the period of legality when LBOs were more intensively screened for the quality of the deal. The examination of the data leads Cumming and Zambelli (2010) to suggest that uncertainty regarding the legal validity of LBOs impedes efficient governance and distorts decision making.

Cumming and Zambelli (2013) extend their 2010 study by examining the impact of LBO illegality in Italy on PE returns (in terms of IRR) and investee firm performance (in terms of EBITDA/sales). In theory, the effects could go either way. On the one hand, when goods are made illegal and there is still a supply of those goods, then prices tend to be higher. Consider for example the market for illegal drugs and diamonds, or the US experience with alcohol prohibition. As such, we may expect returns to be higher as there are fewer LBO deals in periods of illegality. On the other hand, regulation that lowers the quality of the transactions (the type and extent of due diligence and the involvement of the PE firms in governance and management) could reduce returns. The data examined by Cumming and Zambelli are consistent with the latter view: in the period of illegality, PE returns and investee performance were substantially worse, and the likelihood of PE-backed IPO exits was substantially lower. These performance reductions due to illegality were large: almost as pronounced in magnitude as the impact of the global financial crisis.

Cumming and Zambelli (2017) further extend their analyses by focusing more specifically on the economic value of due diligence. They investigate the relationship between due diligence and investee performance, and control for the reverse possibility that expected performance causes due diligence. The data are strongly consistent with the view that more extensive due diligence is associated with improved investee performance. Also, Cumming and Zambelli (2017) show that due diligence is more effective when it is performed by the PE fund managers themselves, and not by external agents including consultants, lawyers, and accountants.

Policy implications

The Italian 2004 LBO reform offers a unique experimental example in the field of entrepreneurial finance to evaluate the economic impact of restrictive regulations. The Italian changes in LBO regulation help assess whether or not an outright prohibition or a stringent financial ban on LBOs would improve the governance and the performance of target firms and the financing structure of buyouts.

The data underlying Cumming and Zambelli (2010, 2013, 2017) show that a prohibition of LBOs is not an efficient policy measure to protect the interest of target firms (see the 65Appendix, Panels A, B, C, for more details on the underlying main findings). Over the period of prohibition, in fact, LBOs were still carried out, mainly with the adoption of multi-layered structures aimed at evading regulatory restrictions and minimizing the transaction risk. The illegality declaration not only inhibited the efficient structure of LBOs but also distorted the decision-making process of PE funds, who seemed more focused on minimizing the risk of a legal dispute rather than adding value to their target firms. The screening process was more focused on maximizing the agreeableness with the management of the target firms, instead of adopting more crucial selection criteria such as the business plan feasibility, market conditions, and growth potential of the target firms. Over the illegality period, investors minimized their involvement in their target firms by retaining just a minority position on the board of directors, having fewer control rights, and lower ownership stakes. This was detrimental for target firms because it negatively impacted their performances.

The LBO legalization, instead, had a positive impact not only on the frequency of buyout transactions but also on the financial structure of LBOs. It produced significant improvements on the governance and performance of target firms. PE funds increased their involvement in their portfolio firms in terms of invested capital, ownership percentage, board control, and other control rights. Furthermore, the legalization of LBOs positively affected the due diligence process, as well as the investor returns and performance of target firms.

The main policy implication from our data is that the interests of target firms and their stakeholders are not efficiently protected by a prohibiting regulation, but rather by other forms of regulation, such as a legalization subject to specific conditions related, for example, to the disclosure of the deal and the business plan feasibility, as was emphasized in Italy with the 2004 corporate governance reform. Other possible forms of regulation could introduce limits on the debt-to-earnings ratio. Future research is needed to assess and empirically investigate the efficacy of different forms of financial regulations.

Conclusions

This chapter highlights the perils of stringent financial bans and regulations in the context of debt merger and acquisitions (i.e., acquisitions that are financed primarily with debt and are completed with a merger between the companies involved). We provide evidence and insights on the inefficiency of excessive regulations by commenting on the empirical evidence related to the Italian PE market, whose transactions were previously prohibited and thereafter legalized. Our empirical analyses are based on a novel proprietary database composed of PE-backed transactions carried out in Italy over the 1999–2006 period and divested over the exit period from 2000 to 2009 (see Panels A, B, C of the Appendix for more details of the main findings of Cumming and Zambelli, 2010, 2013, 2017). Our analyses show the positive impact of the 2004 corporate governance reform that legalized LBOs, subject to a set of specific requirements (“contingent legalization” of LBOs). Our data also show the perils underlying stringent regulations on these types of transactions. Stringent regulations distort the due diligence, the fund involvement, and the allocation of time and attention dedicated to the target companies. These effects are detrimental for the target companies and are against the interests that legislators and policy makers around the world declare to protect.

Since the late 1990s, LBOs have been severely challenged by policy makers, tax authorities, legal scholars, and courts. At the core of the dispute was the interpretation of LBOs as fraudulent tools employed by PE investors in order to evade the law or to deprive target firms of their strategic assets. In 2000, the Italian Supreme Court even prohibited these types 66of transactions because it considered them a breach of the financial assistance ban. Since the early 2010s, the Italian Tax Authority has repeatedly challenged the legitimacy of LBOs by contesting the deductibility of the interest expenses associated with the debt underlying these types of deals. Only recently did the Italian Tax Authority begin to accept that the deductibility of the interest payments connected to the LBO loan are deductible (see the Circular Letter 6/E, March 30, 2016). The Italian LBO reform represents an innovative example of the prevention of abusive opportunistic behaviors by newco companies to the detriment of their target firms. The empirical studies of Cumming and Zambelli (2010, 2013, 2017) show that LBOs are merely financial tools. Like any other tool, LBOs can be used properly or misused. But when properly adopted, they allow a target firm to access alternative sources of funds (De Fontenay, 2014) and contribute to improving the performance of the acquired firms, as well as the fund involvement in managing them (Cumming and Zambelli, 2013).

In response to the ongoing debate on the need for more stringent regulation and bans on LBOs, legislators and policy makers aiming to better protect target firms and their stakeholders could follow the Italian example provided by the new Italian LBO reform introduced in 2004. Instead of prohibiting LBOs, the studies of Cumming and Zambelli (2010, 2013, 2017) show that the target’s interests are better protected when LBOs are legalized under a set of conditions aimed at increasing the disclosure of the deal. Overall, our studies are consistent with the views that the legal environment significantly affects investor behavior and a prohibiting or stringent LBO regulation inhibits the efficient LBO structure and the governance of target firms. It reduces the incentives for PE funds to be actively involved in the management of their portfolio firms and it distorts the PE funds’ decision-making process, to the detriment of target firms and their stakeholders.

Notes

  1    For an overview of the criticism against LBOs, see, e.g., Yeoh (2007); Zambelli (2008, 2012); Thomsen (2009); Ferran (2011). See also: The Economist (2005, 2016); BBC News (2007) and The Guardian (2008).

  2    For an overview of the criticism raised against LBOs by scholars and courts in Italy and Europe, see Ferran (2007); Zambelli (2008); Payne (2011).

  3    Examples of new reforms affecting alternative investment funds are: The Dodd-Frank Reform and the Volcker Rule in the US and the Alternative Investment Fund Manager Directive (AIFMD) in Europe. Both reforms are currently under discussion for a revision. For updates on the various reforms and proposals recently introduced worldwide, see Payne (2011); Gibson and Sullivan (2015); Invest Europe (2017).

  4    The Economist, November 19, 2009.

  5    See also Jensen (1989, 1998); Wright et al. (1992, 1996, 2001, 2006, 2009); Holmstrom and Kaplan (2001); Chou et al. (2006); Kaplan and Strömberg (2009).

  6    For the efficacy of the merger procedure, the approval of the shareholders’ meetings of both merging companies is necessary (article 2501 of the Civil Code). Once approved, the merger becomes effective only after a waiting period of two months has passed; this waiting period has the purpose of allowing the creditors of both companies to oppose the merger (article 2503 of the Civil Code). If creditors oppose it, the merger is suspended and a court must intervene, unless a bank guarantee is granted in favor of the opposing creditors (article 2503 of the Civil Code, III paragraph).

  7    For more details on the LBO deal structure, see Baldi (2015).

  8    Examples of court decisions against the admissibility of LBOs are: Criminal Tribunal of Milan, June 30, 1992; Ivrea Tribunal, August 12, 1995; Tribunal of Milan, May 4, 1999; Supreme Court, February 4, 2000. Examples of court decisions in favor of LBOs are: Tribunal of Milan, May 14, 1992; Tribunal of Brescia, June 1, 1993; Tribunal of Milan, May 13, 1999.

  9    For more details on the European context of LBO regulation, see, e.g., Giannino (2006); Ferran (2007); Zambelli (2012).

6710    Article 1344 was typically invoked to invalidate the merger agreements.

11    Decision of Milan Court, May 13, 1999 with reference to the Trenno case.

12    These types of structures were severely contested by the Italian Tax Authority.

13    For more details, see Negri Clementi and Montironi (2002) and Silvestri (2005).

14    Article 7(d) of the Bill of Law 366/2001 states: “The merger of two companies, one of which had received debt financing in order to acquire the control over the other, does not imply a violation of the prohibition to make loans or provide guarantees for the purchase or the subscription of own shares.”

15    On September 15, 2008, Italy introduced a new law (Legislative Decree 142/2008), aimed at creating exceptions to the financial assistance ban outlined by article 2358 of the Civil Code, in line with the principles included in the European Directive 2006/68. See Rusconi (2008) for more details.

16    See, e.g., Italian Tax Authority (2009).

17    For more details see: Capizzi et al. (2017). See also Morri and Guarino (2016).

18    The Circular issued by the Italian Tax Authority (2016) is available at: https://dato-images.imgix.net/45/1461337783-Circolaren.6_Edel30marzo2016.pdf?ixlib=rb-1.1.0. For more details and comments on the Circular recently issued by the Italian Tax Authority, see, e.g., Clifford Chance (2016); Deloitte (2016); Ernst & Young (2016); Morri and Guarino (2016); Saltarelli et al. (2016).

19    For recent details on the data collection procedure, see Cumming and Zambelli (2017).

20    In the Appendix (Panels A, B, C) we provide a more detailed overview of the main findings underlying Cumming and Zambelli (2010, 2013, 2017).

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71Appendix: Overview of the empirical analyses underlying the studies of Cumming and Zambelli (2010, 2013, 2017)

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