Private equity (PE) in Europe smashed all records in 2006 following a rising trend where the highest number of European buyouts since 1999 has been reached. The number of transactions has declined slightly, from 1,115 in 2004, to 1,100 in 2006, but the total value of these transactions has increased by 40% in the last years.
The growth of the PE market has fostered the debate regarding the need for further regulation. The legality of leveraged buyouts (LBOs) has been subject to dispute in recent years by several American and European courts as well as by legal authors. LBOs consist of the acquisition of the shares of a target company, carried out by a special purpose vehicle using debt to finance the acquisition, leaving the target company with less equity investment and more debt than before the purchase. The debt financing is obtained under the expectation that it will be repaid by the target. As a result, the target pays the economic price of its own acquisition. The magic of an LBO rests in the fact that, if the acquisition debt is fully repaid, the investors will enjoy ownership of a company that has been bought with someone else’s money.
The legality dispute has arisen because LBOs allow a buyer to shift the debt incurred when buying the vehicle’s shares on to the assets of the target company, to the possible detriment of the pre-existing rights of the target company’s creditors and minority shareholders. Further, buyouts typically involve a lack of full disclosure to stockholders and are often characterized by a private knowledge held by the insiders.
The legality of LBOS: Europe and USA
Hostility to LBOs is undoubtedly reflected in European corporate law as leveraged buyouts are often perceived as an indirect and fraudulent instance of financial assistance and, as such, are not immune to the ban imposed by Article 23 of Directive 77/91/EEC under which a company may not provide “financial assistance” for the purchase of its own shares.
In contrast, American courts acknowledge the social utility of LBOs and are reluctant to take a negative prejudicial stance against this acquisition method. The US legal treatment draws an ex post distinction between ‘illegal’ and ‘legal’ LBOs on the basis of whether or not such transfers are intentionally fraudulent.
In light of the remarkable difference that exists between these two regulatory approaches it is relevant to understand whether it is the ex ante or the ex post legal strategy that seems to be more desirable.
The case of Italy: can something be learned?
In order to answer this question an analyses of the Italian experience might be helpful. First of all, even in Italy, the legality of LBOs has long been subject to dispute. Critics have said that LBOs fall within the scope of provisions of the Italian Civil Code that, in some articles, prescribes criminal sanctions for directors who damage the integrity of a company’s share capital through an acquisition or subscription of shares of the company, or, in the case of a merger, cause harm to the company’s creditors.However, LBOs have been treated differently in Italy, in the last eight years. Until February 2000 the legitimacy of buyouts was uncertain. In 2000 the Italian Supreme Court (Corte di Cassazione, February 4, 2000, n. 5503) sentenced leveraged buyouts to be illegal and in 2001 the Parliament specifically requested to reconsider buyout regulation and work towards providing a safe harbor for such transactions. Thereafter on 1 January 2004, a new legislative decree was issued where LBOs were legitimised, subject to the fulfilment of additional information disclosure requirements, and provided they do not violate any financial assistance law.
Recent studies of the Italian experience have shown that the prohibition of buyouts did not prevent them but impeded an efficient transaction structure and distorted the due diligence process for carrying out the investment.
During the period of legal uncertainty and prohibition, leveraged buyouts were approximately 15% more intensively screened for the fit (‘agreeableness’) with the target firm management and 8% more intensively screened for fit with the firm. By contrast, during the period of legality leveraged buyouts were 19% more intensively screened for the quality of the business plan in reference to market conditions and 9% more intensively screened for external market conditions.
Further, during the period of legality, leveraged buyouts were 19% more intensively screened for the efficient investment structure (amount of capital required, ownership percentages obtained in the target firm, time to reach the break even point, strategic fit with the other firms in the fund’s portfolio, IRR). Moreover, private equity firms invested approximately 19-27% more capital and increased their ownership in the target firm by approximately 25% and it was higher the level of involvement in the target’s business activity, in terms of the right to replace the CEO (+18-41%) and willingness to take a majority of the board seats (+ 25-37%).
Overall, the data are consistent with the view that laws prohibiting LBOs results in less efficient LBO arrangements since they give rise to transactions that are less hostile to incumbent management of the target firm so that the transaction will not be contested and deemed illegal. It also gives rise to less investment by private equity funds, fewer incentives for the private equity fund to be actively involved in the governance of the organization, as well as private equity fund due diligence focus over the agreeableness of the target firm management as opposed to substantive factors associated with the business plan and external market conditions.
This evidence also shows that an efficient legal treatment of LBOs should be based on an ex post rule capable of determining whether this type of acquisition method was used negligently or fraudulently in cases of insolvency. This entails, prior to the execution of the LBO, the obbligation to disclose some necessary information that could be used later as evidence in the adjudication process, should the firm become insolvent. Similar rules are adopted, for LBOs of private companies, in England and Wales. The directors render a statutory declaration of solvency, as a necessary condition for a share buyout, in which they declare that there is no foreseeable ground on which the company giving assistance could be found to be unable to pay its debts. This declaration should be regarded as an accurate proof of the directors’ intent.