A family-owned opportunity

Many of those active in the Spanish private equity market look forward to its future. While the past 18 months have been predictably quiet both in terms of deal making and fundraising, general partners and investors alike believe that there are compelling opportunities ahead. On the macroeconomic level, the country can expect to benefit for another decade or so from what might be deemed a convergence premium, with economic growth expected to outstrip the European average as Spain closes the gap on its continental neighbours. Private equity, its protagonists believe, has a key role to play in this process, helping to consolidate the country's fragmented industry sectors and modernising the economy as a whole.

Expectations are centred around the midmarket. Spain has more small to medium-sized businesses than any other country in Europe, two thirds of which are family-owned, so it is here that most general partners expect the industry to find the necessary flow of medium-sized buyouts and recapitalisations that will let it catch up with the more mature private equity markets in other parts of Europe. ?There is a great opportunity to consolidate industries even in capital-intensive sectors where companies lack critical mass,? says Eric Halverson, a partner at mid-market buyout house Qualitas Equity Partners.

The mid-market is the future
Felipe Oriol, president of Corpfin Capital, a private equity firm based in Madrid, believes much of the industry's potential will be realised if it can educate the country's business community. ?Family owners will face the situation when they need to change their companies' capital structure. As I they become aware that we exist, I that we won't interfere and that they I can trust us, that will lead to opportunities to put our capital into play.?

The mid-market is largely the domain of the local houses. Large transactions, such as CVC Capital I Partners' recent €577m purchase I of a cable network from Iberdrola, the utility, are thin on the ground and typically sold to the large international firms that operate in Spain including CVC, Apax Partners, Advent International and Carlyle. According to José Martí, Financial Management Professor of Madrid's Complutense University, the market for large buyouts is becoming increasingly competitive, so much so in fact that a lack of supply of suitable assets brought to market by the relatively few existing corporate sellers is making it difficult to buy at the right price.

But even in the mid-market, deals are difficult to come by. Disagreements on price often stand between buyers and sellers of companies. As Javier Loizaga, managing partner at Mercapital, Spain's largest domestic private equity investor, points out, ?sellers have been slow to adapt to the change in valuations. There have not been enough distressed sellers because the recession has been so mild. The issue now is how deep and long the recession is going to be.?

He says finding deals in the current environment requires a proactive approach on the part of the investor. ?You have to find entrepreneurs and convince them that you have a business plan and that they need your help to execute it. You produce deals by getting into the market and shaking it.?

Mercapital is currently investing its second fund, a €600m vehicle closed in late 2000, which made a significant contribution to the €1.9bn raised by Spanish general partners that year when private equity fundraising was booming. A year later, according to the European Venture Capital Association, Spanish houses raised just over €750m from both domestic and international sources of capital.

Local banks want their piece of the pie
Traditionally much of the capital invested in Spanish private equity has come from abroad. When Mercapital raised its fund, using Merrill Lynch as placement agent, Spanish investors accounted for a mere 10 per cent of contributors. Many domestic institutions are yet to discover the benefits of the asset class as part of a diversified allocation strategy.

Some general partners, when tapping local sources of capital, will do so partly for strategic reasons, while expecting to raise the bulk of their financial resources from elsewhere. When Iberduke, a subsidiary of London-based buyout house Duke Street Capital, opened for business in 2001 as a joint venture with Finpro, a Portuguese private equity firm, with a view to investing in buyouts of up to €300m in enterprise value, it raised some €90m from Spanish retail investors and the cajas de ahorros, the savings banks. But, with significant capital available from the parent company in London, money was not the main reason for the exercise. ?We have the ability to underwrite €200m of investments from London,? says Patrick Maxwell, a director at Duke Street. ?The main incentive was the networks and origination opportunities that these investors could bring. We will be leveraging off our investors, and work very closely with them to identify and check out opportunities.?

Similar considerations about access to deal flow also played a part in Baring Private Equity Partners' teaming up with the Caixa Catalunya, Spain's third-largest savings bank in April of this year. Baring, which has been investing in Spain since 1987, sold a 45 per cent stake in BPEP España to the bank, with a view to securing its support for future fundraising efforts but also to use its network of retail outlets to support deal flow origination – a novel approach, and one that observers say the Caixa can contribute a lot to. ?It is not a coincidence that the Caixa Catalunya is taking a stake in a private equity company,? says Maria Garcia Rubio, a partner at law firm Baker & McKenzie. ?The highest concentration of family owned businesses is in Catalonia.? The region also boasts an active technology scene and a number of research centres and universities – a potent mix.

Both BPEP's and Iberduke's experiences indicate that, despite difficult market conditions, appetite among Spanish institutions for private equity is growing. And their ambitions don't simply extend to becoming limited partners, particularly as far as the savings banks are concerned. As Maxwell points out, when Duke Street was in the market fundraising for Iberduke, some of the bigger cajas wanted to talk about taking a stake in the venture, which Duke Street declined.

Private equity investment is a relatively new area for the smaller savings banks to operate in. ?The deals they have done in the past have been small regional deals. I think they are now moving away from that old way of doing venture capital and going for a more professional approach to investing in unlisted companies,? says Maxwell.

It's no surprise that more banks are looking for a piece of the action. Spain's largest banks, BSCH and BBVA, are already well established in private equity. BSCH has been particularly active. Its subsidiary Vista Capital, a joint venture with Royal Bank of Scotland, was behind the purchase and subsequent roll-up of Superdiplo, a supermarket chain, which market participants describe as one of Spain's paradigmatic buy-and-build transactions. La Caixa, another large savings bank, also set up a subsidiary recently.

Where are the pension funds?
The challenge for Spanish institutions that are new to the asset class is to find a way to break into it and to get started in a market that is notoriously unkind to new entrants. ?Newcomers in Spain aren't very well received,? observes Martí. ?It's better to buy into an established presence.?

There are several reasons why institutions are keen to become involved in private equity. Not so long ago, Spanish government bonds offered such high returns that, like in Italy, institutions didn't need to think very much about their asset allocations. Fiscal discipline and the Euro have changed that, and there are few alternatives. The public equity markets aren't attractive, and the corporate bond market is a new and uncertain place. So investors are spending more time looking at private equity.

?The risks in private equity may be significant,? comments Carles Ferrer, an investment manager at Riva y Garcia Private Equity in Barcelona, ?but the balance sheet is insulated from the immediate market volatility because it is a long term investment.?

Where institutional enthusiasm for private equity products is yet to spread in any meaningful way is among Spanish pension funds. Even insurance companies, which in 2001 according to EVCA provided less than nine per cent of total funds raised from Spanish sources, have some way to go to feature more prominently in private equity, but pensions, which accounted for a mere 0.2 per cent of the total, are practically not represented in the asset class at all.

Eduardo Lopez is general director of the Iberia pension fund, which manages a total of €850m in assets. Of that, less than 1 per cent is currently invested in private equity. Lopez is an experienced investor in the asset class: ?We meet up with the big funds from time to time. We talk about their experiences. I have been investing and talking with private equity funds for seven or eight years.?

Pension funds are still constrained by some regulatory restrictions, although Lopez expects them to be removed soon as a result of European directives. ?But even so, we still wouldn't invest more than two to three per cent in private equity,? he says.

As José Martí points out, even taking it to that level would be major step forward compared to most other Spanish pensions. He isn't sure why pensions are still so reluctant to invest in private equity: ?Early on there was a lack of information, then pensions were too risk averse. Now funds have switched into the stock market but we are still waiting for the switch into private equity.?

What may help persuade Spanish investors of the merits of more private equity exposure in their portfolios is that the regulatory framework has been improving for some time. Most significant was a law introduced in January 1999 and subsequently modified in 2000, which grants private equity firms a 99 per cent tax exemption on profits made from the sale of equity more than one year (but not more than 12) after the initial investment. There have also been changes to the tax rules governing holding companies and venture capital vehicles designed to further the deployment of Spanish capital into private equity funds.

Leverage at last
But the real test lies in whether Spanish GPs will succeed in finding value in the country's mid-market, helping those family owners take their companies to the next level. One development that will be making it easier for them to fulfi this task is that both domestic and foreign banks are inten' on developing their leveraged lending capabilities.

Leverage has long been conspicuous by its absence, and the leading buyout operators such as Mercapital and Excel Partners have generally done deals without any. Bu' European banks including Bank of Scotland, Crédi Lyonnais and Royal Bank of Scotland are already active in the market, and are expecting Spain to become an important market for their leverage teams. Some of the local houses are following their lead. Even European mezzanine providers have started to take an interest London-based Intermediate Capital Group is among them having recently hired an investment executive for Spain One of many signs that the market is preparing for a significant increase in investment activity.