Abstract
Based on four Surveys on Italian Manufacturing Firms spanning the 1995–2006 period, we investigate the characteristics of those companies that use internal equity as the only source of capital for financing their positive-NPV investments. Firms that are more likely to make an exclusive and pro-cyclical use of internal equity to finance their investments are mainly located in the North and Centre of Italy and tend to be steadily profitable but not export-oriented, not innovative and R&D spenders. Their prevailing family business model limits the use of external equity and debt, thus favoring the resort to internal equity. The resulting lack of resources for innovation makes it impossible for them to grow and sustain a competitive advantage. This is an economic disgrace as the total value added of sample companies represents 0.75 % of the Italian GDP in 2006. Our claim is that the active involvement of private equity investors would have a multiple, positive impact on them. An explanatory framework is developed in this respect. Stronger policy efforts should thus be directed towards promoting the growth of a private equity market in Italy by removing the barriers that still prevent it from having a positive, real impact on the real economy.
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- 1.
This is mainly due to the tendency of treating financial issues of small and medium-sized firms as private information.
- 2.
Unicredit is the leading bank group in Italy and one of the major banks operating in Europe.
- 3.
As of the latest survey conducted in December 2008 and referred to the 2004–2006 period.
- 4.
Internal equity capital users are those firms that retain earnings in order to finance their capital expenditures and external equity capital users are those resorting to the informal channel of business angel investors, venture capital (VC), private equity (PE) or public stock market via initial public offerings (IPO) when financially supporting their positive-NPV projects. The order of priority in using such forms of equity financing depends on the specific phase of the business life-cycle the company has entered: the earlier the stage of realization of the entrepreneurial idea, the more likely the demand for capital from angels and VCs. More mature businesses would instead raise equity via PE investing or IPOs.
- 5.
In so doing, we confirm the empirical results from Fenn and Liang (1998), who find out that in the U.S. market companies obtaining external equity in the form of PE investments are a small proportion compared to the universe of small and medium-sized firms, and growth is pursued via financing projects based upon earnings retention and bank lending.
- 6.
As far as a firm’s gearing ratio (debt-to-equity) is concerned, the focus here is on the quality of the denominator (provided that the level of the numerator is financially bearable).
- 7.
Past literature relies on four major surveys all produced in U.S.: National Survey of Small Business Finance (NSSBF) (1993); Wisconsin Entrepreneurial Climate Study (WECS) (1986–1991); Federal Reserve Bank Call Report on small business lending (FRBCR); Survey of Consumer Finances (SCF) (1995) (Wolken 1998). The NSSBF, co-sponsored by the Board of Governors and the U.S. Small Business Administration and at its second edition, provides a representative sample of U.S. non-farm, for profit, non-financial small firms. Data from this survey are used by Petersen and Rajan (1994), Berger and Udell (1998) and Ou and Haynes (2006). The WECS is a survey produced by the Marquette University on active young firms and is used by Fluck et al. (1998). The Bank Call Report—not properly a survey, but a Federal Reserve census—is an important dataset on the use of external debt in U.S. (with a size limit of $1,000,000 for reported firms to which loans are granted). The SCF, conducted by the Board of Governors on U.S. households, is particularly helpful for studying the relationship between business ownership and personal assets.
- 8.
Such assumptions are: the absence of transaction costs, the availability of the same information about the firm to both managers and investors, the full access to debt and equity instruments.
- 9.
Coleman and Cohn (2000) also argue that asymmetric information is such an inherent feature of small and privately-held enterprises that pecking order theory is particularly applicable in such a context.
- 10.
Signaling theory argues that the owner’s willingness to (re)invest in his own business may serve as a signal about a firm’s asset quality and earnings prospects. Pecking order theory suggests that managers (insiders) tend to issue new shares only when the firm is overvalued (growth prospects are not good). However, such a recourse to public equity reveals the above “internal” information to investors (outsiders), thus destroying the insiders’ informational advantage. Such an information asymmetry problem is resolved if a priority order is followed in choosing the means of financing: (1) available liquid assets (formed via earnings retention) are first used to financially support positive-NPV projects; (2) debt financing may be subsequently used in that it is less correlated with future business conditions; (3) external equity is issued as a source of funding of last resort. Pecking order theory implies that the proportion of funds arising from earnings retention increases with the rise of firm size and decreases with the erosion of its growth prospects. If (and until when) the firm grows generating enough earnings, management will exploit this source of funding and resort to external finance thereafter (Fluck et al. 1998).
- 11.
Michaelas et al. (1998) find out that small U.S. companies prefer not to raise external equity in order not to dilute control, thereby considering earnings retention as the most important source of financing followed by bank-originated debt. High-growth firms entering their expansion stage are instead more likely to employ external capital, as they may have exhausted their internal equity sourcing. Two further studies that rely on data from the NSSBF provide support for Berger and Udell (1998)’s theory of financial growth cycle. Cole and Wolken (1995) draw data on about 4,000 U.S. firms surveyed in the 1993 NSSBF to find that only one-quarter of the smallest firms (but three-quarters of the largest ones) are financed via bank lending. Hence, smaller firms are more likely to be funded through internal equity capital. Similarly, Gregory et al. (2005) find evidence that, while smaller firms are more reliant on finance provided by insiders, larger firms are more likely to employ long-term debt and public equity.
- 12.
Financial capital provided by the owners (equity, loans) increases from 25 to 40 % of total financing as the firm approaches middle age due to earnings accumulation over time (Berger and Udell 1998).
- 13.
In this sense, angel and venture capital funding may play a complementary role as firms grow (Wetzel 1983; Fried and Hisrich 1994; Freear and Wetzel 1995; Barry 1998; Wright and Robbie 1998). Indeed, the upstart firm would initially solicit angel finance and replace it with VC-based capital as the firm grows beyond the funding capacity of the angel investor.
- 14.
In particular, Ang (1992) argues that both the goals and risk preferences of the family running the business are critical in finding the right match between suppliers of capital and small firms. Bolton and Freixas (2000) suggest that while riskier firms prefer bank loans, safer firms tend to issue shares and bonds to avoid intermediation costs. Xaio et al. (2001) find that education, age, race and personal net worth are important factors in determining firms’ risk-taking attitudes and behaviors. Other work suggests that graduate education significantly influences the odds of using external equity financing by women entrepreneurs (Carter et al. 2003).
- 15.
Papadimitriou and Mourdoukoutas (2002) —focusing on equity financing in U.S., Israel and Ireland—assess the impact of the “less direct” methods employed in U.S. at public level to stimulate the venture capital industry compared to the “more direct” methods (such as public–private partnerships and public ownership of venture capital funds) applied in the rest of the considered countries. Tucker and Lean (2003) examine the equity financing gap faced by small businesses and investigate about the informal financing initiatives promoted by policy-makers.
- 16.
For an excellent review of regression models for categorical and limited dependent variables, see Long (1997).
- 17.
By pooling random samples drawn from the same population, but at different points in time, we can get more precise estimators and powerful test statistics. For details on pooled logit regressions, see Wooldridge (2002).
- 18.
See Fig. 2.1 for GDP growth rate in each survey period.
- 19.
For the sake of simplicity, industry-related controls are omitted in Table 2.2.
- 20.
Model (2.4) is run by using the maximum likelihood estimation method (firm and time subscripts are overlooked for the ease of exposition). Common statistical tests have been performed to validate the robustness of the model.
- 21.
Our findings are in line with the empirical evidence provided by: Michaelas et al. (1998) about the prevalence of financing for growth based on retained earnings and/or a mixed capital structure among small U.S. companies; Chittenden et al. (1996) on the likelihood of positive-NPV project funding via earnings retention for more profitable small and medium-sized firms; Coleman et al. (2007) on small and mid-sized manufacturing firms operating in New England (USA) that are shown to be privately-held, family-owned and highly profitable with a prevailing exploitation of such earnings for fuelling growth and a lower use of external equity.
- 22.
Furthermore, as the entry of new shareholders is not allowed by family members and the presence of debtholders is rare due to the prevailing use of internal equity, any agency problem (with the related costs) associated with equity or debt becomes irrelevant. This implies that the Jensen and Meckling (1976)’s model does not apply in this context.
- 23.
More generally, Beck and Demirguc-Kunt (2006), relying on various cross-country evidence, argue that access to finance via innovative instruments can play a significant role in shaping the small and medium-sized, competitive business environment. More specifically, Bloom et al. (2009) show that private equity-owned firms are on average significantly better managed than government, family and privately-owned companies (after controlling for a number of firm characteristics such as country, industry, size and employee skills). These results arise from use of a new, robustly-informing survey tool developed by the same authors to collect and measure management practices (with associated ownership data) across firms and countries (Bloom and Van Reenen 2007). It is a double-blind methodology in that both interviewers are not told anything about the financial performance of the firms they interview (performance blind) and managers are not informed that they are being scored (scoring blind). Such a survey tool is applied to 4,000 PE-owned and other firms in a sample of medium-sized manufacturing firms in the U.S., Europe (including Italy) and Asia over the 2004–2006 period.
- 24.
They show, in a 3 years’ time-lag, the fastest improvement of management practices compared to all different ownership types.
- 25.
Practically, the CEOs of PE-owned firms have a “boss” represented by the PE fund’s general partners.
- 26.
Queen (2002) suggests that an area for public intervention may consist of those companies growing at a below-average pace characterized by high risk and low return (and thus not attractive to VCs).
- 27.
AIFI is the Italian Association of Private Equity and Venture Capital, which has identified the key deficiencies of the Italian PE market in line with the above three barriers indicated by investors: (1) limited development of domestic channels for fundraising; (2) small dimension of the overall market, in terms of number of active PE houses and deals closed; (3) restricted access to turnaround financing for troubled firms (White Papers, March 2006 and July 2008, AIFI).
- 28.
Fiscal treatment of a PE fund proceeds from liquidation of investments is quite complex in Italy and is different for individual and institutional investors. To the former, starting from July 2011, the fund distributes gross proceeds, which are taxed at 12.5 % (tax rate applicable to capital gains, dividends, etc.) at individual level. The 12.5 % tax rate will raise to 20 % starting from January 1, 2012. Before July 2011, all proceeds were taxed (at 12.5 %) at fund level regardless of their distribution. Even capital gains or dividends only accruing to the fund were subject to taxation. Indeed, the fiscal treatment of proceeds distributable to institutional investors differs for pension funds and corporate entities (banks, insurance companies). Proceeds to the former are always taxed at 12.5 % (20 % from 2012) and thus they are indifferent between directly investing equity into a company and committing the same equity to a PE fund. Proceeds to the latter are instead qualified as proceeds generated from a fund (and not from the underlying portfolio company) and are thus taxed at a higher tax rate (27.5 %). This does not apply if the same proceeds are distributed from an holding company (capital gains are fully exempted from taxation; dividends are exempted at 95 % with only 5 % of them being taxed at an effective tax rate of 1.375 %). It results that corporate entities would prefer the second mode of investing as opposed to a PE fund.
- 29.
No uncertainty should be allowed as to the fiscal treatment of the carried interest as capital gain (subject to the 12.5 % tax rate; 20 % from 2012) and not as earned income (subject to the 45 % tax rate). To avoid disputes with the fiscal authority and minimize fiscal burden (to 12.5 %; 20 % from 2012), general partners are still typically asked to make a commitment of at least 2 % of capital to the fund.
- 30.
The current limits of interest deductibility applicable to Newcos established for the purpose of realizing LBOs are not justifiable if one looks at the cautious and balanced use of financial leverage in recent deal-making that well-matches the characteristics of target firms (see Table 2.4 in the Appendix).
- 31.
The portion of financial charges exceeding such a limit is carried to the next fiscal year for deductibility’s purpose. More precisely, leasing installments expensed for a given year are also included in the above calculation.
- 32.
The numerical exercise is conducted by normalizing and averaging the relevant items from 2006, 2007, 2008 and 2009 income statements of the 898 internal equity-using firms selected within the 2004–2006 portion of the SIMFs’ overall sample.
- 33.
The general rule of thumb suggests that, with an interest coverage ratio below 1.5x, the firm is assumed not to generate cash enough to satisfy all its debt obligations. In all cases shown in our numerical simulation (except in 2009), the selected companies can shrink their earnings by a maximum of 68 % and still be able to meet potential interest expenses. Besides that, it must be noted that the safety range of 3–5x is typically lowered under depressed economic scenarios with low interest rates, which applies to the 2008–2009 period considered.
- 34.
The reform has abolished the register of bankrupt entrepreneurs by aligning the Italian bankruptcy law to those of other countries such as Germany (Insolvenzordnung, 1999), France (Loi de sauvegarde des enterprises, 2005), and U.K. (Insolvency Act, 1986; Enterprise Act, 2003).
- 35.
PE investments: € 5.5 billion (2008) versus € 4.2 billion (2007) (Grant Thornton—GT, June 2009). Number of companies invested: 284 (2008) versus 251 (2007); +13 % (GT 2009). Average investment: € 19.9 million (2009) versus € 16.4 million (2007), with an historical average of € 7.5 million in the 1986–2009 period (KPMG-AIFI Survey, May 2010).
- 36.
Both annual and historical pooled IRRs reported in the KPMG-AIFI Survey are calculated on the basis of those investments and the associated divestments of a minimum 30 % equity stake made in 2009 or across the whole 1986–2009 period respectively.
- 37.
In 2009, the new PE investments are made using the following type of financing: buy-out (43 %), expansion/development (35 %), turnaround (16 %), replacement (6 %) (Private Equity Monitor, May 2010).
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Appendix: The Private Equity Market in Italy: Key Features and Performance
Appendix: The Private Equity Market in Italy: Key Features and Performance
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Baldi, F. (2013). Who are Private Equity Targets?. In: Private Equity Targets. SpringerBriefs in Business. Springer, Milano. https://doi.org/10.1007/978-88-470-2826-5_2
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