The objective of this article is to offer a perspective on the evolution of search funds in Italy, using the experience of Guido Fileppo, one of the first Italian searchers, as an example. Moreover, it provides a framework to understand the impact that this instrument would have on Italian SMEs, which appear to be aging and declining in number (Corriere.it).
Guido Fileppo is a 35-year-old Italian entrepreneur returning from various professional experiences abroad. After being awarded an MBA in INSEAD, he decided to launch a search fund called Patria Private Capital, built on the model developed by Stanford.
SMEs in Italy represent 99.9% (SBA Fact Sheet 2019) of total enterprises present in the country, with most of them (94.9% of the total number of enterprises) being categorised as Micro companies. Moreover, 66.9% of the value added in the Italian economy is provided by SMEs against an EU average of 56.4%, highlighting the central role covered by these enterprises in the Italian environment.
However, there are some dynamics that might hamper the long-term prosperity of Italian SMEs. Two main ones are:
- The aging of entrepreneurs
- The financing choices to gather capital
Regarding the first point, in the period between 2010 and 2020, the number of individual enterprises in Italy has fallen by 230k (as of March 2020 they were 3.1m). However, this fall has not been homogeneous among age groups [Table 1].
Hence, it is possible to observe that the number of young entrepreneurs fell dramatically while the opposite can be said for people over 50. Consequently, enterprises owned by the older echelon (>50) represent now 66.4% of the total, compared to the 54.8% of ten years ago.
On the other hand, the second reason that may hinder the long-term prosperity of Italian SMEs is connected to the financial tools used to finance the operations. Indeed, these enterprises have been historically characterized by a strong reliance on debt financing. However, Graph 1 highlights some trends in corporate financing in which Italy lags with respect to the EU average. Thus, such finding makes it clear that, on one side, equity funding is still scarce, and on the other hand, that banks are reluctant to give out small loans, with a cost of borrowing which is on average higher than the rest of the EU.
Even though more innovative financing instruments have been introduced as a result of the 2008 global financial crisis (e.g., minibonds, invoice trading, PE & VC, etc.), the post-pandemic scenario will be very likely characterised by low interest rates. Thus, the level of debt will raise again due its low cost.
In this context, search funds represent a new model emerging in Italy, and the innovation introduced by such funds may be an opportunity to overcome the challenges associated with the Italian funding ecosystem. Thus, it provides new means to raise equity while preserving the key pillars of Italian entrepreneurship.
There are many companies in Italy that fall into the typical target category of search funds. We are talking about firms that generate between €5-20m in turnover and are growing at a considerable fast pace. Therefore, these are small companies, typically managed by >60-years-old CEOs with long experience in their respective field. It is pivotal for the searcher to look for an entrepreneur ready to make the generational change. The search fund model is very much like a VC-type investment, where investors’ willingness to provide capital is more driven by the choice of the searcher and the managing team rather than the target company itself. Besides sound revenues and EBITDA figures, one important KPI to look at when selecting the target is represented by the cash conversion ratio, i.e., how well the EBITDA is converted into cash. Such metric tells the investors whether the business is capital intensive (or not) and whether the company generates enough cash to repay the outstanding debt raised to finance the acquisition.
The investment objective
The main objective is to reach, on average, a 35% IRR and, normally, the investment horizon lasts 5 years. However, the searcher’s goal is to stay even longer as there is no time-limit to liquidate investors (as it usually happens in private equity). Investors do not expect to exit in 5 years, which is why many search funds have been active even for 20 years. In the beginning, the search fund receives an initial capital that spans from €300-600k, depending on whether there are two searchers or not. Moreover, it is important to point out that in the standard search fund contract, there is no obligation to invest, but rather a right of first refusal – an investment option. Consider the situation in which an investor commits 10% of the search capital. In such a case, he or she will have the opportunity to invest 10% of the capital needed to make the final acquisition. If the investor decides not to invest this 10% quota, then the option to invest is given to the other members of the search fund. If nobody is willing to invest these 10%, capital can be raised from outside investors. Therefore, notice that there is always a second phase of fundraising carried out at the time of the target acquisition. At this stage, it is important for the searcher to convince investors of the good prospects of the target, since the final equity capital invested in a target should be in the range of 2 to 10 million euros. Finally, it is relevant to consider that these transactions often take advantage of financial leverage, in the form of an LBO, with a debt-to-equity ratio of 1 as a top threshold.
Based on the above analysis, it emerges that search funds represent a very good tool for the Italian ecosystem to preserve the typical Italian entrepreneurship style, while involving, at the same time, the younger generations, and introducing a more innovative (and equity-based) way to finance Italian SMEs.
The role of investors
The Italian search fund is traditionally composed of 10-12 investors, not all of them being active. During the search phase, there is not much activism among investors. The decision to actively involve investors is up to the searcher, who may find it convenient to ask for the intervention of an investor with relevant experience in a particular sector, as Guido Fileppo did by exploiting the knowledge of private equity investors about specific industries. Overall, many investors enjoy investing in a search fund because, in addition to being able to choose whether to commit capital or not, they know they can be active despite not being on the board.
Factors affecting search funds’ success in Italy
On one side, the search fund model benefits from less strict regulations in Italy as compared to SGRs (Società di Gestione del Risparmio – Asset Management Company), because capital is raised through a private placement that does not involve institutional investors, which implies almost no regulation imposed by the Bank of Italy and no yearly licensing fees (required instead for SGRs). On the other side, a negative factor is represented by the overall Italian vision that young people do not have the appropriate skills and experience to manage a company. Indeed, search funds must deal with this issue while fostering the opportunity to younger professionals to re-gain their space in the Italian entrepreneurial scenario.
Ec.europa.eu. 2021. Italy – SBA Fact Sheet 2019. [online] Available at: https://ec.europa.eu/docsroom/documents/38662/attachments/16/translations/en/renditions/native
Vico, D., 2021. Perché i piccoli imprenditori in Italia sono sempre più over cinquanta? Lo studio. [online] Corriere.it. Available at: https://www.corriere.it/economia/aziende/20_luglio_15/perche-piccoli-imprenditori-sono-sempre-piu-over-cinquanta-4b374030-c65a-11ea-a52c-6b2a448f1d2c.shtml
Authors: Giacomo Nicoli, Filippo Zocco
Editor: Tiago Guardão