Approaches to market positioning of Private Equity firms in Italy

The term Private Equity indicates, on a global level, "the investment activity in the risk capital of unlisted companies, with the aim of valorising them and then divest them in the medium-long term". Typically, this activity is carried out through the typical operational structure of so-called Funds. 

The involvement of Funds goes beyond simple financing; in fact, their function is that of implementing previously defined growth strategies, improving operational efficiency, increasing turnover, diversifying the product/service portfolio and penetrating new markets. Through this partnership, investee companies can undertake a growth path and therefore improve their operational efficiency and strengthen their competitive position. To valorise the acquired companies, Private Equity funds now implement consolidated development strategies such as, for example, working closely with the management of the companies involved, contributing not only specific skills and know-how in the reference industry, but also a vast range of financial resources.

The principles described above represent the general guidelines that are common to the different types of Private Equity Funds, although each of them has a specific investment strategy, normally defined as "IC - Investment Criteria" and a specific orientation in each of the following areas (briefly summarized by way of example):

• the maximum amount of investments, i.e. the fund's equity contribution to investment operations (Ticket);
• the development stage of the target companies (Stage); 
• the geographical location (Geography); 
• the reference industry (Industry).

Generally, although each fund has unique characteristics, based on the type of investment (majority/minority), the investment ticket (small/mid/large cap), and the maturity of the targets (growth/value) there are common criteria for each tier of the matrix. For example, in the Italian market, approx. 70% of PE operations (by number of operations and not by cumulative value of the same and/or by level of AuM of the Funds) target small-mid cap companies (which is quite logical, since 95% of enterprises are SMEs). Therefore, the funds operating in this segment have common ICs, such as preferring majority investments, targets with stable/growing cash flows (representative of countercyclical sectors), MBO (management buy-out) operations - also meant as re-investment of the founding members, etc. Likewise, the rationales also have common features, such as the structuring of an efficient managerial line, the internationalization of the business and the inorganic growth of the target, through a build-up process.

However, despite the common criteria of the different Fund tiers (listed above) as well as the common rationales (improving operational efficiency, increasing turnover, diversifying the product/service portfolio and penetrating new markets), in recent years, there has been a change in the specific ICs that characterize the tiers, bringing the methods, forms and investment criteria of all Funds closer together, regardless of the ticket and other factors. In fact, considering the Italian situation, from 2012 to 2019, there was an increase in Leverage Buy Out (LBO) and Expansion (investments in growth companies) operations compared to the past, which had previously suffered a sharp slowdown in the post-2008 global financial crisis – given the significantly high implicit risk. In fact, the contraction of the ECB reference rates, as well as the quantity of money issued in the ten-year period, have, among other things, encouraged the financial economy linked to M&A operations, allowing PE Funds to leverage a smaller use of own capital in their acquisitions and, consequently, make investments with a higher risk/return ratio (growth investments).

As regards LBO operations, prior to 2008, we could see 80-90% financial leverage (especially in the US), while, in subsequent years, leverage was almost nil due to the psychological shock of the American banking crisis and pessimism in the market outlook. In the years following 2012, although there was a re-integration of leverage into market practices for PE operations, it did not exceed 50-60%. Furthermore, in Italy, LBO operations established only from 2003 onwards and did not represent the most used structure until 2011-2012. In recent years, the market situation (consequences of the 2008 crisis) together with a complex socio-political situation in Italy, have implied that Italian companies, due to the implicit risk, be essentially "economical" to the eyes of foreign investors, who have imported more sophisticated financial structures based on a constant use of financial leverage (but also mezzanine financing, preferred equity, etc.).

Therefore, in the years from 2012 to 2020, Italy experienced a segmentation of funds into different tiers (based on ICs), due to the progressive increase in M&A operations and specialization of the funds themselves. In 2020, following COVID-19, we experienced an unpredictable event linked to causes external to the market, i.e., the pandemic. In fact, the lockdown marked a transversal slowdown of the economy, which translated into declining (in many cases, negative) cash flows. Furthermore, following a period – which lasted for approx. 8-10 years – characterized by an easy access to credit and an economic expansion, many SMEs showed “distorted” cash flows due to these factors and not directly attributable to real growth of the business. Therefore, COIVD-19 had a catalytic effect on the crisis of many companies, which were already in a precarious economic and financial situation.

The result has been an extremely volatile market regarding corporate cash flows, which has led the various Funds to investigate their own ICs and subsidiaries. The ultimate consequence was the review of investment criteria by financial players, opting for counter-cyclical businesses with extremely solid fundamentals (paradoxically, 2020 has become an extremely relevant reference year for understanding whether a target is based on a solid business model and whether it has concrete market penetration or not). Therefore, the Funds that invest in Italy today are always partially divided based on investment tickets, target maturity, reference industry, etc., although, at the same time, there are common requirements for finalizing an investment (for example, in the pre-pandemic years, Funds usually concentrated investments in one or few close industries, focusing on geographically close companies and with similar business models, while, today, there is a search for portfolio diversification and, in any case, for solid companies, as well as highly developed industry expertise to be able to understand the quality of a business).

Essentially, on the one hand, Funds have started to look for common characteristics in companies across different industries, diversifying the geographical risk, since there is no longer a limit of investment in a very small specific area, and the trend of specialization of Funds has continued compared to the post-financial crisis years, albeit in a different way (not as concentration in few industries, but rather relying on industry experts to better analyse the reference industry as well as the positioning of the company in the same). Compared to a market in which easy access to credit, together with complex financial architectures – based on the LBO archetype – has generally favoured investments in companies with a high level of risk/return, now the trend has returned to be that of a more detailed analysis of the underlying assets (research of solidity in the fundamentals) of the targets, as well as of stable markets in different economic situations (defensive and, generally, anti-cyclical markets).

The change in ICs, in many cases, has led operators to implement a new organizational structure, dismantling the traditional closed-end Fund and moving to less rigid forms, with variable perimeter, and with the fundamental possibility of involving not only institutional investors ( typically: banks, insurance companies, pension funds and funds of funds) but also individual investors whose contribution can be not only a capital contribution but also a contribution of intangibles, such as: industry skills, operational, organizational and commercial networking, credibility, in order to be able to better evaluate the fundamentals of companies.

Finally, Investment Clubs, Continuation Funds, Search Funds, Permanent Capitals, etc. are also being introduced into the Italian market, not only amplifying the number of available operators, but also providing companies with a considerably wider range of solutions, which can better adapt to their strategic needs.

The analysis and data presented in the “Expert's opinion” and in the “Focus on” articles are the result of the research "Analysis of the evolution of the positioning strategies of Private Equity funds in Italy from 2013 to 2023" by Sante Maiolica and Lorenzo Bocchieri.