Offshoring 2.0

Those same businesses realized that they could drive costs down still further by sending their outsourced work abroad. Low-skilled service jobs like telephone call centres, data input and in manufacturing, component assembly could be done at a fraction of the cost in countries like India or China. Some thought then that this was the high watermark of globalisation. But they are about to be proven very wrong. The truth is we have only just got started. There is a fundamental imbalance in the global economy; in the post-industrial nations, capital is cheap, but labour is expensive. Conversely, in the developing world, capital is scarce but labour is plentiful. Economically this would suggest the huge potential for mass immigration. Yet politically with today’s pressures on emerging multicultural societies, it is a total non-starter.

That’s why offshoring could be seen as the most acceptable route forward to politicians and businessmen who embrace globalisation. Thanks to the advances in low cost digital communications, the world economy is on the verge of Offshoring 2.0 – a revolutionary new paradigm in the way we do business. In the very near future, for small and medium size businesses, having partners in the Pacific Basin will no longer seem exotic, but the norm. Bookkeeping? Email your tax returns to a Chartered accountant in New Delhi. Need a long production run in a short period of time? Go to Southern China, the new workshop of the world. Even Governments are flirting with offshoring, contracting out exam marking to developing countries. It will be big business though who takes the lead. By some estimates, up to 40% of their currently outsourced jobs, could be next in line to be sent offshore. In 2003, just 3 – 4 % had been moved abroad. The lower ranks of the professional classes – lawyers, accountants, medical practitioners, computer programmers and even financial analysts – are next in the firing line. Are we all ready for this?

Certainly there will be losers. In his recent book, “Outsourcing the American Dream”, Christopher England argues that offshoring is a short-sighted way of making profits, while eliminating your most valuable asset, your employees. But the vast majority of us will be winners. The new jobs that are created tend to be higher paid and more interesting. 12 years ago, huge and successful companies like Google or Amazon did not exist. 12 years from now, there will be many others. The falling cost of manufactured goods like DVD players from China has enriched all living rooms, whilst call centres in India can reach us after work at home. The arrival of the digital age has massively reduced the costs of communication and this is pricing in three billion workers from the developing world. A recent report by the Association for Computing Machinery on globalization and offshoring of software stressed the mutual benefits to India and the USA in jobs and profits in increased trade.

Nor is this just a phenomenon of the Anglo-Saxon world. It’s a strange twist of fate that Senegal, who’s introduction to France was enforced slavery 600 years ago, now is the low cost location of choice for France’s call centre companies. Even Japanese companies have set up call centres in Northern China (where Japanese is spoken). Perhaps the biggest question is – where does it all end? One would have to speculate on what the industries of the future will be. Intellectual property, alternative energy, maybe even artificial intelligence. What we do know is that the global economy is almost certainly going to continue down the route of mass specialisation and the constant redivision of effort. Offshoring is just starting to open up huge opportunities. Tomorrow’s financiers will be very, very busy.

The world needs more private equity, not less

After a record long period of low inflation and high profitability, the world economy is awash with cheap capital. One of the unforeseen consequences of this is that we have a new mainstream asset class to get excited about – private equity (PE). Some analysts looking to the near future, forecast a world where the typical portfolio contains a 5-15 percent weighting in private equity. But are they right, and just how did private equity rise so far and so fast and what is all the fuss about?

Before setting out the case for private equity, it’s worth understanding the uncomfortable truth that public markets aren’t quite as good as we think they are. Stock markets have four intractable problems; large numbers of inactive shareholders, large shareholdings by fund managers who value instant performance over long-term investment, rising compliance costs in corporate social responsibility, reporting and media activity and finally, ‘free cash flow dispersion.’

The last point is perhaps the most crucial of all. Back in 1986, Michael Jensen, now a Professor at Harvard Business School, theorised that the managers of public companies when generating more profits than they can reasonably invest in their industry, instead of returning the cash to shareholders, all too often hold on to the cash and diversify. These new investments are typically aimed at a new field where they have less expertise and generate lower returns. This trend, the dispersal of cash flow by vested corporate interests, arguably, has led to the rise of the underperforming conglomerate, so idealised in the 1950s as the benevolent corporation.

The initial backlash to this corporate sloth occurred in the early 1980s, led by financiers funded by the cheap debt of the day, junk bonds. Their aim was to asset-strip (or reallocate) the conglomerates’ assets and return the value back to the shareholders in cash. This continued until the late 1980s when a slumping economy and rising interest rates put paid to their financing by cheap debt.

Twenty years on, private equity financiers are again drawing down debt, re-tuning businesses and starting new ones. Asset-stripping is not a principal activity of theirs, far from it.

But what private equity financiers do do, which is virtually identical to the 1980s is to take an ‘active investor’ role. Back in the 1980s, James Goldsmith defined the active investor as the following: “An active investor is not a manager, not a particularist, he’s not a man who thinks he can double-guess management, he’s not a person who thinks he can do a better job of management than the management he can hire. An active investor has to ensure that the right management is in place, the right management is properly motivated, the right management, properly motivated, then runs the company according to a reasonable strategy and doesn’t chase industries it knows nothing about. That is the job of an active investor. If he does not consider the management is right, he fires it and replaces it.”

So some of us can see that active private equity investors are far more of a corporate tonic than having a couple of fund managers on your back. The resurgence of private equity is the quite right and proper claim of capital to reassert its interest against the onslaught of political and regulatory distraction.

PE critics meanwhile point to the “major transparency and accountability gap” outlined by the Walker Report which they say needs closing. They seem all to ready to ignore that businesses, as long as the law is obeyed and competition is free, need only be transparent and accountable to their owners. And private equity has long done this far better than any public company.

Moreover, as the number of easy deals declines in the Anglosphere, PE will start to reach out much further afield. And be under no doubt, a global private equity boom will be unleashed when cosy corporatist nations like Japan, France and others feel the whip of the active investor.

Japan, more than anywhere else in the world could benefit from aggressive private equity. Many companies hold underperforming assets in property, all too often, one of the largest assets on the balance sheet. Private equity could be the divine wind that shakes corporate Japan to its core, igniting the animal entrepreneurial spirits the country so desperately needs. Still today, many Japanese companies seem to think that their company is run for the workers and managers, while shareholders are only entitled to a bond-holding interest.

The truth is that PE is an obvious example of how business succeeds with lower taxes and minimal political interference. London in the meantime, has a chance to make itself a world leader in private equity by cutting tax on carried interest still further. Politicians and trade unionists should either shove off or join the ride.
The global private equity revolution has only just begun.

Dan Lewis is Research Director of the Economic Research Council www.ercouncil.org

The nightmare of a Chinese economic collapse

In 2001, Gordon Chang authored a global bestseller “The Coming Collapse of China.” To suggest that the world’s largest nation of 1.3 billion people is on the brink of collapse is understandably for many, a deeply unnerving theme.

And many seasoned “China Hands” rejected Chang’s thesis outright. In a very real sense, they were of course right. China’s expansion has continued over the last six years without a hitch. After notching up a staggering 10.7 percent growth last year, it is now the 4th largest economy in the world with a nominal GDP of $2.68trn.

Yet there are two Chinas that concern us here; the 800 million who live in the cities, coastal and southern regions and the 500 million who live in the countryside and are mainly engaged in agriculture. The latter – which we in the West hear very little about – are still very poor and much less happy. Their poverty and misery do not necessarily spell an impending cataclysm – after all, that is how they have always have been.

But it does illustrate the inequity of Chinese monetary policy. For many years, the Chinese yen has been held at an artificially low value to boost manufacturing exports. This has clearly worked for one side of the economy, but not for the purchasing power of consumers and the rural poor, some of who are getting even poorer. The central reason for this has been the inability of Chinese monetary policy to adequately support both Chinas.

Meanwhile, rural unrest in China is on the rise – fuelled not only by an accelerating income gap with the coastal cities, but by an oft-reported appropriation of their land for little or no compensation by the state.

According to Professor David B. Smith, one of the City’s most accurate and respected economists in recent years, potentially far more serious though is the impact that Chinese monetary policy could have on many Western nations such as the UK. Quite simply, China’s undervalued currency has enabled Western governments to maintain artificially strong currencies, reduce inflation and keep interest rates lower than they might otherwise be. We should therefore be very worried about how vulnerable Western economic growth is to an upward revaluation of the Chinese yuan. Should that revaluation happen to appease China’s rural poor, at a stroke, the dollar, sterling and the euro would quickly depreciate, rates in those currencies would have to rise substantially and the yield on government bonds would follow suit. This would add greatly to the debt servicing cost of budget deficits in the USA, the UK and much of Euro land.

A reduction in demand for imported Chinese goods would quickly entail a decline in China’s economic growth rate.

That is alarming. It has been calculated that to keep China’s society stable – ie to manage the transition from a rural to an urban society without devastating unemployment – the minimum growth rate is 7.2 percent. Anything less than that and unemployment will rise and the massive shift in population from the country to the cities becomes unsustainable. This is when real discontent with communist party rule becomes vocal and hard to ignore.

It doesn’t end there. That will at best bring a global recession. The crucial point is that communist authoritarian states have at least had some success in keeping a lid on ethnic tensions – so far. But when multi-ethnic communist countries fall apart from economic stress and the implosion of central power, history suggests that they don’t become successful democracies overnight. Far from it. There’s a very real chance that China might go the way of Yugoloslavia or the Soviet Union – chaos, civil unrest and internecine war. In the very worst case scenario, a Chinese government might seek to maintain national cohesion by going to war with Taiwan – whom America is pledged to defend.

Today, people are looking at Chang’s book again. Contrary to popular belief, foreign investment has actually deferred political reform in the world’s oldest nation. China today is now far further from democracy than at any time since the Tianneman Square massacres in 1989. Chang’s pessimistic forecast for China was probably wrong. But my fear is there is at least a chance he was just early.

Dan Lewis is Research Director of the Economic Research Council www.ercouncil.org

The decline of Wall Street

The answer is London, Switzerland and to some extent, even Germany. It is astonishing that over the same period, the UK’s surplus went from $7.6 billion to $25.3 billion. And Switzerland, the world leader for offshore finance, nearly doubled from $6.6 to $11 billion.

There is tremendous competition for financial services and America – as a domicile – is not winning. Take initial public offerings for example. 10 years ago, it was all the rage for companies to list on Nasdaq. Today, some of those same foreign companies are delisting themselves, finding the quarterly reporting requirements amid other costs, just too onerous. According to a report commissioned by the London Stock Exchange, The Cost of Capital: An International Comparison, in 2005, the European exchanges raised more new money from IPOs and attracted more international IPOs than the US exchanges.

It is particularly prevalent amongst smaller companies. Underwriting fees in Europe at 3-4% are half what they are in the USA. The clear winner though has been London’s junior market, the Alternative Investment Market or AIM. This accounted for 52% of Europe’s IPOs last year. AIM is winning the business because it does not require that a company have any minimum market capitalization, stockholders’ equity, trading volume or share price. Add to that for small to mid-cap IPOs in the $20 to $100 million range – getting analyst coverage is perceived to be easier in London than in New York. So for London at least, small has become the new big.

IPOs may well be the headline grabbing business, but now there are new markets like credit derivatives that have come from nowhere to a notional $7.5 trillion in just 10 years. Derivatives were invented by the Mesopotamians thousands of years ago. But in the 19th Century, Chicago led the way with its futures markets for grain and pork bellies. This has not been since translated into a comparative advantage in derivatives – made ever more complex with the help of computer modelling. London now has 40% of the world derivatives market.

The underlying lesson is that capital is moving faster and more efficiently than ever before. If higher returns can be found out of America or indeed anywhere else there are no real barriers to its reallocation. So perhaps that’s why Hank Paulson is dropping strong hints that he is in favour of reform of the Sarbanes Oxley Act.It is pricing American markets out of a future that used to be theirs. No question, America’s financial regulation has become a burden. And only competition in the form of globalisation is forcing Americans to confront this reality.

Global financial innovation and competition have only just got going. And not even America can afford to rest on her laurels. 

Prepare to wobble

They cannot achieve equilibrium and overshoot continuously by over-supplying or under-providing any given good or service. This led to a ‘dynamic disequilibrium’ and always resulted in bubbles, booms, recessions and downturns.

Today, this is a mainstream view. Many now accept that markets are in a permanently quixotic quest for efficiency, so it’s fair to say that at any stage, the world economy is unbalanced. But that does not mean that it is unstable. In recent years, there has been an ominous change. Volatility has been growing, the wobbling, shown in America’s sub-prime liquidity crisis, has begun. In 2007, the world economy could lay claim to $167trn of financial assets.

Those assets are looking seriously overweight in high-risk trailer trash debt, Anglo-Saxon and Iberian Real Estate and above all, US dollars.
But the really big change in the near future will be who will have the most momentum, or ‘the big mo’ behind the next investment wave?

According to an October report by the McKinsey Global Institute, ‘The New Power Brokers of Global Capital Markets’ are increasingly going to be Asian central banks, oil investors (both of which you could categorise together loosely as sovereign wealth funds), private equity and hedge funds. Looking ahead, the projected infusion of capital from these intermediaries means that they are going to take over from mutual funds, pension funds and the banks as the chief arbiters of global capital.

And that’s no bad thing. They will collectively go some way to righting the imbalances of the world economy by seeking an honest return. And we will enter an even more liquid financial world.

Yet there is no escaping the imbalances, the overshoots, in the world economy. The question to ask though is exactly what is causing them?

The main culprits are fixed exchange rates, a liquidity explosion at the bottom, the state ownership of natural resources and above all, a lack of financial imagination. Authoritarian governments have a weakness for fixed exchange rates, believing that they have superior knowledge over the market of what the true value of their currency – and economy – should be.

In China’s case, this tends to favour large exports of manufactured goods, albeit at wafer-thin margins. This has for China created an enormous pool of foreign currency reserves, some $1.2trn. Yet the Chinese implicitly understand that money, even dollars, are not a store of value, merely a transferable token of debt. That’s why they are diversifying out of these dollars, setting aside $300bn for investment purposes – a figure that can only rise.

Meanwhile, the poorer parts of the global economy are woefully short of debt. As Hernando de Soto wrote in his award-winning book, ‘The Mystery of Capital,’ the world’s poorest lack basic property rights, which would enable them to secure debt financing, to raise capital to do anything.

The long-term answer has to be for developing world central banks and governments to return their surplus cash flows from central banks and state-owned natural resources in the form of vouchers or tax cuts to their people. This could engender the evolutionary flexibility and portfolio diversification that is the key to success in the 21st century economy as described by Eric Beinhocker in his excellent book, ‘The Origin of Wealth.’

No question, markets are going to become more and more efficient at allocating capital to maximise returns. That suggests dollars and euros, will lose out in the long-term value stakes to the Chinese Renminbi, physical commodities and emerging market equity. Like the cult exercise regime of Pilates, these wobbles can only make the world economy stronger. And be assured, without them, we’d be all the poorer.

Urbanisation 2.0: the mother of all building booms

In a recent video conference lecture, Ex-Vice (and still wannabe) President Al Gore said; “in the next 40 years, there will be more building than in the previous 3,000 years.” In this of course he saw great environmental risks. Global financiers on the other hand should see huge opportunities. When most of the world’s 3.54 billion rural population decide to move into the cities, a massive shift in their expectations occurs. Think about it. These ex-villagers will want clean, hot water on tap, not the stagnant kind from the well. They will require grid-tied electricity and air-conditioning, not a smoke-filled hut. And above all, they will demand a space to call their own, probably a car and plenty of good places to shop.

Urbanisation 1.0 which accompanied the West’s industrial revolution in the 19th Century was trivial compared to the scale and speed of what is happening today. Even by 1900, just 220 million of the world’s people, 13 percent, were living urban lives. That’s why Urbanisation 2.0 – the 21st Century version – is a mega-trend that can’t possibly be ignored and is one that investors must embrace.

For sure, the infrastructural challenges are enormous; bringing transport, housing, energy and water to a few billion people for the first time. Naturally, there are those who would say this can’t or it shouldn’t be done. They should be ignored. Progress, ultimately, is unstoppable. The pertinent question to ask though, is how can it be done, financially?

At the micro level, these new – but poor – urban slum dwellers, will eventually want loans, credit and insurance. On housing at least, you can forget them taking out 25 year mortgages. In 2001, prize-winning Peruvian economist Hernando de Soto argued very persuasively in his book ‘The Mystery of Capital’ that what was lacking in developing nations were legally enforceable property rights and that’s what kept them poor. In other words, because most of the world’s poor have no formal ownership deeds, they are unable mobilise those assets – be they businesses, property or livestock – to use as collateral against debt. Micro-finance then, has the potential to go a very long way from here.

Transport is another area fraught with huge difficulty. In China, cities with a few million people are being erected in mere years and national vehicle ownership is forecast to rise from 30 million to 140 million by 2020. Already they have 16 of the world’s 20 most polluted cities, principally due to exhaust fumes. To their credit, the Chinese are working on this furiously, no doubt motivated by the possible embarrassment of choking athletes at next year’s Olympic Games in Beijing. It is however a universal problem and there can only be three solutions; cleaning up personal transport, increasing public transport and reducing urban density. My guess is that the most likely outcome is that as oil prices drift upwards, markets will deliver the first and politicians will talk up the second while quietly endorsing the third, by expanding the suburbs.

But can you plan for efficient future cities?
The West unfortunately does not have a great deal to teach the developing world in planning. Urban design as a profession is at least 2,000 years old. Today’s municipal planners dream wistfully of Timgad, a perfectly symmetrical, self-contained grid-laid Roman town in Algeria built in 100 AD. Instead they have given us the likes of Milton Keynes in the UK, one of the world’s first ‘New Towns’ and by common consent, a soulless failure. Looking back, it would have been far better to expand London. So the lesson for planners is this; urbanisation works at its best where scaleable infrastructure is put in place, first and citizens are given maximum choice to expand from the existing hub, second.

The future city of the West in 2040 will have resolved many of those issues that currently elude us; clean air, reliable public transport and effective municipal government. Between now and then in developing world cities, all of these will probably get worse before they get better. But catch up they will. Competing in the global economy is like a race without a finish. And only those cities which offer both good economic prospects and a high quality of life will stay ahead. So take a long bet on cement, bricks and mortar. Urbanisation 2.0 has only just begun.  

Dan Lewis is Research Director of the Economic Research Council. www.ercouncil.org

The end of the global real estate boom?

And these last few years, its value has been booming. In the US alone, one-quarter of the jobs created there since 2001 have been in construction, real estate and mortgage finance. The world economy has withstood a dotcom bust, international terrorism and high oil prices. Yet many are now starting to believe that a real estate bubble has been propping up the World Economy and it’s about to burst. The trigger – they contend – could be a sharp fall in the US Housing market. This is because America is 30 percent of the world economy and its consumer spending has been part-fuelled by rising house prices.

No question, the returns in property have been unprecedented, both in the size of the gain and the spread of countries involved. In the last five years, the price of the median US home is up an inflation-adjusted 50 percent. The world’s highest return though has been in South Africa, 227 percent from 1997-2004, according to The Economist House Price Index.

The hard question is why?
In many countries, one could fairly cite a shortage of supply, cheap credit and planning restrictions. But that’s not the whole story. Real estate is being touted as an investment, appreciating faster than inflation and incomes for many years to come. This is nonsense.In many ways, real estate is a terrible asset class. It’s illiquid, it’s expensive – there are high transaction costs and it usually involves taking on very large debts. Curiously, it is nothing like as well researched as much smaller stock, bond or even forex markets by analysts or economists.

We have all also somehow being led to believe that a rise in house prices is good for the economy. It is not. When property prices rise faster than incomes – as they have done in most economies for at least a decade bar Japan and Germany – this has made people much poorer in real terms. Unlike companies that sell more products more profitably, housing stock does not intrinsically improve its output. It is merely valued on future rental income or more worryingly, anticipated capital gains – the definition of a speculative bubble.

To use the jargon, the world economy is overweight in real estate. In the UK, 59 percent of £6trn of assets is tied up in property. That’s three times the annual GDP output. Yet whilst the value of real estate is a floating market price, the cost of its underlying debt is a hard-numbers certainty. That means that the fallout from a global housing bust could be pretty spectacular.

It is at the top end of the housing market that prices have gone into the super league. In 2004, according to Forbes, there was only one home in the world priced over $100m. In 2005, there were four. There is a new class of internationally mobile wealth driving this end of the market. It started with the Russians moving into London. Many anticipate that the same will happen with China, Brazil and India.

So how long can the property market keep booming?
America is key and it is cooling off fast. With the US Fed rate recently raised to 5.25 percent, the days of cheap money are over. Consumer spending – part financed by mortgage equity withdrawals – has been outpacing income and this is not sustainable. Economic historians will tell you that housing booms always precede recessions. Another factor is the rise of the teleworker, already millions strong, made possible by broadband internet connections. 10 more years of improving bandwidth just might truly internationalise the global workforce and signal the end of the high density and expensive commercial city centre rents. Anyone who thinks a property bust (a fall of more than 30 percent) following a boom will not happen need only look at Japan. From 1991-2005, Japanese property prices dropped for 14 years in a row, by 40 percent.

So any retiring Western couple intent on selling their home and moving abroad to the sun should try something else. Rent out your home, rent more cheaply abroad and live off the difference. Your assets – property, stocks or otherwise – should perform for you, not the other way round.

Dan Lewis is Research Director of the Economic Research Council
www.ercouncil.org

Zanchi hopes for a better Italy, unsure of Berlusconi

Only the fittest survive. Yet in a truly global economy it is often only those with the cash to expand that thrives and survives. And Italian companies, often small to medium sized concerns, usually know this better than most. Yes, says Roberto Zanchi from Milan legal firm Pavia e Ansaldo, the credit crisis has seen a general tightening of capital investment, but private equity deals are still being done he says. “Much of the deals we are seeing are for heavy industry projects. Energy. Heavy industry. But Italy is always a bit special in this regard. We have so many more modest sized companies so that, in a sense, means the targets are much wider.”

Yet on home ground, more unpredictability is underfoot. Romano Prodi’s limping left-of-centre government is expected to be replaced shortly, possibly by Berlusconi once more. The euro’s strong rise has also piled pressure on Italy’s exporters. (Some critics even suggest Italy could be tempted to leave the eurozone – but such a move could also bring huge economic instability).

So, given that Italy remains in dire need of an economic overhaul, private equity and mergers are probably even more likely.

Sector lowdown
Italian M&A/private equity activity predominates in several sectors, notably energy, fashion and heavy industry. Despite the difficult of raising capital, the fractured nature of Italy’s industries – namely a lack of cohesion and collaboration also aids opportunity for investors. Taking the long view, Italy’s economic woes are also nothing new – and perhaps investors should also take comfort from that, despite Prime Minister Prodi being voted out of office, subsequently unleashing a political power vacuum.

But international investors do gain from Italy adopting much of its M&A modelling from the US and the UK says Zanchi. Many M&A agreements resemble Anglo-Saxon practices. Also the level of Italian legislation is highly developed when it comes to tender offers he adds. General principles of Italian law, including the issue of good faith, also protect investors within the Italian legal framework.

The EU has also had a positive influence, particularly with its Directive on Crossborder Mergers, making acquisitions easier.

A good time to buy?
It’s difficult to know the implications of a return to power by Silvio Berlusconi. Zanchi says that even if Berlusconi’s Forza Italia party returns to power, he doubts the economic climate will change dramatically. “Really, the ability to make more or less deals is linked, we would say, to the general economic conditions, rather than by a specific approach or line taken by the political parties.”

However Italian growth was only 1.5 percent last year – little more than half the eurozone average of 2.7 percent. Which means the eurozone’s third largest economy continues to underperform, affecting valuations. Productivity remains low across many Italian industries and the unofficial black market economy remains frighteningly high. Part of the problem for many Italian companies is being tied to the euro. Without being able to periodically devalue its economy – as Italy regularly used to do with the lira – it has become much more difficult to keep its exports competitive.

Certainly with the current credit uncertainty, those international investors electing to buy now could be a canny move says Mr Zanchi. But Roberto Zanchi warns that striking the right balance between a fair price and valuation for assets – not to mention getting the right mix of capital and debt – needs careful weighing. “Banks are being more prudent these days with their lending. There is a different ratio of debt and capital required.”

Personal relationships are key
Despite some economic gloom and more political uncertainty, many Italian small businesses are increasingly feeling more confident about the economic opportunities available says Zanchi. “Certainly in the last nine months or so, we’ve seen a lot private equity interest and that means that these smaller companies correspondingly feel a greater sense of opportunity.”

Hanging on though for the highest bidder is not typical behaviour for many Italian family-run companies however. Because of the often huge family sensitivities about their business, any sell is often based on good personal relations between the parties, not just hard cash says Zanchi. “Often it’s about having a good personal feeling between the parties. So a deal is not always about reaching the highest price. It’s also often about making sure there is a minority stake too, so that family interest is retained.”

Italian business has also become particularly sensitive to previous private equity operators buying up businesses only to sell them on, dismembering the less profitable parts quickly. “What is important is to give the seller the sense that everyone gains – all the shareholders –from a deal. It’s not just about the money.”

Given the increasing rise of M&A and private equity deals, many Italian companies are also feeling more confident about just how negotiations are structured. Increasingly it is about the seller’s priorities reminds Zanchi, not just the buyer’s priorities. “We have had so much competition now from private equity buyers that many Italian businesses are becoming more adept, more confident at handling their own interests. It also makes the transaction easier when all parties are aware of just what everyone is getting into.”

Negotiating the hoops

Despite the obvious attractions of many Italian businesses to the private equity community, there remain considerable obstacles to navigate warns Zanchi. For example, a wave of new Prodi-led business regulations has attempted to force companies to restructure. Some companies are still in the stages of revamping their own internal workings which could mean problems further down the line.

However, leveraged deals are growing in acceptability and there is a growing acceptance of employee financial instruments, even if the Prodi administration deliberately held back progress back here.

Specific pitfalls
Labour relations are critical, with many Italian companies taking a ‘freestyle’ approach to company and employment law. Differences can be stark between north and south in terms of interpreting the law, and the input of the unions are always critical

Italian privacy legislation can be obstructive, especially for international investors wanting to dig deep below the surface

On-going social security responsibilities can be onerous and complex to understand, especially for overseas investors. The Prodi-led administration has done much to shore up workers rights, making it harder to employ part-time and temporary staff warns Zanchi

Be aware that Italian business legislation has made more progress in ensuring agreements do reflect all the terms of a deal says Zanchi. This means more flexibility for dealing with existing by-laws and provision against third parties. “And it means more protection around issues such as lock-up and rights of minority and majority shareholders, plus veto powers.”

Debt level and management control is critical
The current credit crisis has certainly made a difference to possible lending routes. But a private equity deal using a leveraged structure will mean a level of indebtedness. “That’s probably one of the most important issues for Italian companies now. Can the target company continue to repay the debt following such a move?”

Zanchi adds that any international buyer will need to look very carefully at how they retain management. “It’s such a critical aspect. One issue is how to create or structure an incentive package for the new management and to what degree it uses cash or stock options. But be aware that stock options have become less attractive under the current [Prodi] administration.”

Do be aware also that though Italian administrations can often talk enthusiastically about reform and investment incentives, following through is often less predictable. In other words, it’s important to factor in a certain amount of unpredictability, not to mention maximising your own personal protection too.

Planning your exit

Who decides when the time is right to exit? It’s a tough issue acknowledges Zanchi. “The exit issue is always a big consideration and a big part of the discussion for the parties. Often in the past, the prospective purchaser and seller would often differ substantially in how they approached this, however I would say that now it’s widely accepted that if a seller wants to take profits from their private equity transaction, then so be it, within a certain time frame.”

It’s also an issue of Italian culture points out Mr Zanchi. “The whole issue of taking profits or the consequences of an IPO is more widely accepted. But if the domestic Italian company is convinced of the private equity player’s professionalism, then that gives you a different perspective to the deal. To see it from their side. But if you don’t trust the private equity player, or their capacity to maximise returns, then you should not go with them. Full stop.”

For further information
Tel: +39 02 85 581
Email: info.milano@Pavia-Ansaldo.it
www.pavia-ansaldo.it