In late June, international equity investors were examining two of this year's highlights in capital markets transactions: the $1 billion IPO for Italian advertising and television group Mediaset and a similar-sized issue of bonds exchangeable into the Italian government's holdings of shares in insurance group Istituto Nazionale delle Assicurazioni (INA).
That Italy should provide two such high-profile new issues in quick succession may be a sign of even greater things to come. John Hyman, a vice president at Morgan Stanley, says: "The Italian market is at a very interesting point in its development. Several trends are at work which could dramatically transform it over the next three to five years." These include: the growth of increasingly sophisticated institutional investors in Italy and a stronger appetite among foreigners for Italian shares; the privatization programme itself; and, perhaps most importantly, the greater willingness of small and medium-sized Italian companies to undertake a public listing.
Largest convertible
The Mediaset deal has aroused intense interest among Milan stockbrokers and foreign investors alike, partly because of its large size and partly because of judicial investigations into the affairs of Fininvest, the company run by former prime minister Silvio Berlusconi, which is Mediaset's 71% majority shareholder. (This stake should fall to just below 50%, after the deal goes through and if minority shareholders exercise their options to buy additional shares.) Equally intriguing is the potential for profits and growth at this fast-growing and aggressive company. Most Milan brokers expect the deal to be a considerable success, even though some potential investors may be scared off by the investigations into Finninvest.
The INA deal eventually came at $2.35 billion of sovereign bonds, in separate dollar and lira tranches, exchangeable into INA shares. It is the largest convertible bond ever issued in Europe and a vindication of the use of convertibles as a privatization method at a time of general investor fatigue. It will allow the Italian government to reduce its 34% stake in the company to around 10%.
Over 500 institutions clamoured for a piece of the deal, providing a welcome sign that, just a few weeks into the life of the new Prodi government, the Italian privatization programme is back on track. This autumn the government will sell a second tranche of shares in energy group ENI, hoping to benefit from the strong performance of shares since the IPO late last year. Before then, it will sell a further block of shares in banking group IMI.
Investment bankers in Milan and London describe this as a sensible and achievable programme. They contrast it to the over-ambitious plans of previous Italian governments which thought they could issue one huge privatization IPO after another. The new administration is more realistic. Most bankers guess that the privatization of Stet, originally slated for 1995, will not now take place before 1997. The government will be busy with its newly-announced programme until the autumn and then the sale of Deutsche Telekom will crowd other telecommunications stocks out of the new issue market. Nor will the sale of electricity utility Enel - like Stet mandated in 1993 and first scheduled to proceed last year - go ahead until next year.
"It's a pragmatic calendar," says Jurgen Dennert, head of equity capital markets at IMI in Milan. "It's a fair amount to do, but the Italian market, though small, is probably able to absorb more than its reputation suggests."
This is welcome news to several potential corporate issuers, eyeing the new issue market. "We are having conversations now with entrepreneurs and owners of mid-cap companies about coming to market, which we could not have had two or three years ago," says Claudio Costamagna, executive director at Goldman Sachs. "In the past they simply would not listen. Now most of them are at least thinking about it. For the first time there are signals of Italy gaining a serious market in a short time-frame."
This would be a dramatic change. For years the Italian stock market has repelled foreign and domestic investors alike. It is dominated by a handful of large industrial and financial stocks, with a heavy weighting towards banks in a country with one of the most backward and inefficient banking systems in the developed world. These available stocks miserably fail to reflect the true strength of the Italian economy: its entrepreneurial, family-owned businesses in sectors such as light engineering, foods, fashion and other luxury goods.
The Italian casino
As a result, foreign investors have come and gone, driven by pure macroeconomic factors and political considerations. When Berlusconi came to power, they sold. Following Romano Prodi's election victory, they bought. Italians themselves regard the stock market as little better than a casino. Given the high real yields which the heavily-indebted government is forced to offer on its bonds, few Italians even consider buying stocks for dividend income. They buy in the hope of share prices rising, which they occasionally do dramatically in a market which is often manipulated by a few insiders - including companies dealing in their own shares. The result has been an equity market in which sudden sharp rises are followed by long periods of under-performance.
For years, Italian banks ignored the stock market, leaving trading to small, poorly-capitalized brokers. Companies themselves funded their operations largely through bank loans. The system was often political. Banks were publicly-owned and run by political appointees who directed loans to companies run by political allies. Small businesses also relied on bank borrowing, often using the owner's personal portfolio of Italian government bonds as collateral.
Because interest payments are tax-deductible, the more leveraged a company is, the less tax it pays. And in a country with corporate tax rates of 53%, companies are very sensitive to anything that might reduce their tax bill.
Now that system is collapsing. Italian banks are confronted with a shrinking net interest margin between deposits and loans, the staple source of income which still accounts for three-quarters of bank earnings. They face competition for deposits from new mutual funds, some run by ambitious foreign groups. Deutsche Bank, for example, is already the ninth largest fund manager in Italy, offering a family of funds devoted mainly to low-risk bond market investments. It has just bought, and still manages separately, the country's second largest fund manager, Finanza Futuro. Angelo Papa, head of financial products at Deutsche Bank in Italy, predicts: "The fund management business is set to explode."
Bad debt burden
Its growth has already been rapid. Deutsche Bank started its first Italian fund in December 1992, then worth Dm30 million. It now manages Dm7 billion worth of Italian savings in 22 different funds. Increasingly, Italian banks have to fund themselves with interbank money and certificates of deposit which cost more than their old deposits. Many Italian banks show a miserable single-digit return on equity, some as low as 2.5%. Most are trying to build new businesses, the obvious one being fund management.
They are also embracing the stock market. On a recent roadshow around the country to promote the idea of listing to Italian companies, the Milan stock exchange for the first time received support from the country's banking association. Meanwhile, banks are learning the lesson of bad debt burdens. "Banks are becoming more cautious about the gearing ratios of companies to which they lend and, given that family finance is not infinite, that will encourage companies to come to the market," says Paolo Azzoni, managing director of Italian stockbroker Gamba Azzoni, now part of Paribas Capital Markets.
Companies now see the stock market as a more competitive source of funds. This is partly because family owners are attracted by the chance to float a small portion of their company's shares and retain control while establishing a market valuation for their remaining shareholding, the greater part of the family wealth. The approaching moment when a company founder must hand over control to the next generation is often a crucial time. While industry first boomed around Milan and the car industry in Turin in the 1940s and 1950s, it was not until the 1960s that many more technologically-advanced companies grew up in the north-east of the country. This is now its boom region and the home of many candidates for listing as they face the generational change.
New issues by Italian companies over the last 12 months have enjoyed an encouragingly strong market performance. The share price of Brembo, which makes high-quality car braking systems for the likes of Ferrari and Porsche, rose 56% in the 11 months following its listing last August. Investors in luxury goods company Bulgari have enjoyed an even better return, with its share price rising 157% from its launch in the same month. Even large deals, such as the huge ENI privatization, have enjoyed a healthy 30%-plus improvement in the share price.
Foreign institutional investors, in particular in the UK and US, are queueing up to buy growth stocks at a time when they think their own markets may be running out of steam, and Italian IPOs are potentially a great source of these growth stories.
In the past the Italian tax system has hindered the development of the equity market. Interest payments on a company's debt enjoyed exemption from tax, unlike dividend payments which had to be paid after tax. Recently, the tax authorities have tried to make listing more attractive. Medium-sized companies increasing their capital by 15% through the sale of new shares have enjoyed a reduction in corporate tax of 16% for the three years from 1994 to 1997, and it is hoped this advantage will be renewed. The stock exchange has done its part by waiving listing fees for the first two years to newcomers to the stock market.
Other hurdles to listing are being overcome. Italian companies have fretted about disclosure, partly because they did not want to reveal their true profitability to the tax authorities. "Now, the size of the black economy is rapidly decreasing and fear of publishing information should also diminish," says Paolo Braghieri, director at CS First Boston. One reason why Italian companies appear to trade on high multiples of earnings per share is that it is widely assumed that published profitability understates a company's real performance. Tax avoidance is less easy than it once was. "Even many non-listed companies now have properly audited balance sheets," says Alberto Albertini, managing director of the stock brokerage which bears his name. "So there is less chance to hide profits. Such companies have already made the cultural leap, so that they are now much closer to being listed. And many of the owners have read about the fortunes made by entrepreneurs listing their companies on Nasdaq."
Enormous appetite
Other companies may be taking a more strategic view of developing their sources of capital. Hyman says: "A lot of middle-sized Italian companies have proved very good at making their businesses more international and even global, because the domestic market is so small." Many Italian companies, especially those exporters which have benefited from the devaluation of the lira since 1992, face the challenge of consolidation. They have to find ways to fund further growth, or consider selling out to competitors. Hyman recalls working with Italian oil-servicing company Grove, which had annual sales of $300 million to $400 million on a possible IPO before its owners eventually sold to a trade buyer. Bulgari was a company that chose the other route and listed.
Costamagna at Goldman Sachs points out: "A world-leading Italian company in its niche with, say, 50% of its sales outside Italy will find itself competing against foreign companies which also have the stock market as a source of funds. A few are even thinking of developing their shares as an acquisition currency."
While investment bankers point to 15 new listings in Italy in the last 12 months, many of these, including Brembo, have come from private equity buyers, including funds managed by foreign banks like Schroders and Barings, which are seeking an exit from buy-out or buy-in investments. Niccolo Nuti, head of capital markets at Credito Italiano, injects a note of realism into all the excited talk about the Italian capital markets: "Given the recently introduced tax advantages and the huge number of entrepreneurial, family-owned companies, we have really seen very few IPOs other than from venture capital funds."
That very scarcity partly explains why so many newly-listed Italian companies have seen their share prices double in just a few months from listing. Also, many of these small companies were listed on the basis of annual sales growth of 20% to 30% which they have managed to sustain. They have generated an enormous appetite among retail investors and foreign institutions alike.
Now Italian brokers are looking forward to the listing of Mediaset because it is a much larger corporate IPO. Even at a cheap initial price, designed to overcome investor concerns about the arrest of Finninvest executives, the deal is likely to value the company at $4 billion to $5 billion. Already this year, Finninvest has successfully sold shares in life insurance and mutual fund group Mediolanum, in which it is still a major investor along with the Doris Group. Together the two still control 73% of Mediolanum. But its combined offering of 32 million new and secondary shares in May was oversubscribed some 30 times.
Mediaset is a huge deal by comparison. If it flops the Italian market may struggle to cope with it. If, as many expect, it succeeds, it could encourage more large private sector issuers.
But what sort of stock market will these companies launch their shares on? The total capitalization of the Italian stock market is just 30% of the country's GDP, compared with 120% in the UK. The privatization programme has given some critical mass to the exchange through the listing of huge new companies like ENI and by attracting trading capital. Trading volumes on the Italian stock exchange are just beginning to approach the respectable levels of the Amsterdam, Frankfurt and Paris exchanges. Daily volume of $300 million to $400 million is common, with at least one day of $1 billion of volume most weeks.
Building the stock exchange
Still, the market is vexed by illiquidity. Some shares scarcely trade and the stock exchange council has spent many hours struggling to find a solution. Some suggestions have been bizarre, such as the idea of creating more local exchanges for regional companies to trade their shares. This idea was championed by some regional Italian banks, which saw their chance to dominate these markets and confirm their close relations with companies headquartered in their areas. It seems to have been quietly dropped, to the relief of most stock market participants, including one stock exchange council member who describes it as "really, a stupid idea. We have room for two markets at most: the main market and a second sector for small aggressive growth companies to use as a first step to a full listing. Developing anything else is a waste of time and money."
Other solutions to illiquidity, particularly in the shares of smaller companies, are being considered. One is that continuous trading should be replaced with price fixing three or more times a day, with buy and sell orders rounded up for less traded stocks. Another idea is to require a specialist broker to provide liquidity, partly with its own funds, partly with capital supplied by the company itself. A simpler solution might be for stricter rules on the minimum amount of shares that a company must offer when it first goes public. Companies floating too few shares create illiquidity. Some sources at the stock exchange feel these companies should be required either to sell additional shares or to de-list.
For the moment, listing rules are administered by state regulatory body Consob. This may change. Next year, the Italian stock exchange will become a privately-owned company with 51% of its share capital held by market participants (which may include foreign intermediaries), instead of being a publicly-owned body. Its present council - with representatives from local chambers of commerce, the Bank of Italy, Consob and banking associations, as well as stockbrokers - will give way to a new board of directors elected by those new shareholders. Consob will continue as regulatory overseer. But the new exchange may be free to rewrite its listing rules.
Privatization of the stock market itself will not encourage companies to list, but it may have more than symbolic significance. "Privatization is a pragmatic choice," says stock exchange chief executive, Benito Boschetto. "We think that only as a private body can we develop an aggressive practical policy towards domestic markets and to international markets." He adds: "We have many natural candidates for listing. A new aggressive leadership group at the stock exchange may be able to fertilize the financial culture in Italy, where the stock market has not been popular. We need to develop regulation for investor protection and transparency, as well as promoting listings."
Boschetto is well aware that the exchange in Milan faces some competition from foreign markets. Several large and well-known Italian companies, including luxury goods company Gucci, sports-shoe maker Fila and spectacles manufacturer Luxottica, have all chosen to bypass the Milan exchange and list their shares in New York. Companies in certain sectors may think they can achieve higher price multiples for the shares they are selling by going to markets outside Italy. A New York stock exchange listing may also confer some prestige on the majority owner of a big-name Italian company.
Italian stockbrokers fear they must defend their territory against encroachment from other quarters. Albertini says: "I am sure the Paris stock exchange has tried to attract Italian companies, so far without success, and the German bourse will probably try to do the same."
There have been particular reasons for some companies to list their shares outside Italy. Fila and Luxottica have more than 60% of their annual sales in America. Other Italian companies may not be so keen to list outside their home country. Clearly Boschetto's long-term ambition for the new private sector Italian stock exchange is to play with a stronger hand in the game between European stock exchanges, and it might forge alliances with one or more.
At least Italy seems to be building a stock exchange comparable with those of its European neighbours. Its systems stand comparison. It has screen-based trading and five-day rolling settlement. That's an improvement on the bad old days of the 1980s, when settlement could take weeks and insiders might trade many times in shares before delivering them or paying for them.
A single passport
If the Italian stock market is to grow, it is important that Italian banks devote more capital and resources to it. However, it is not clear how Italian banks will proceed: it is an oddity of the country's financial system that it boasts not one major European bank. A few have attempted to build decent investment banking businesses, including Mediobanca and IMI. The treasury regularly shares out mandates for privatizations between these two banks and they have learned much from working with bulge-bracket international global coordinators. Banco Ambrosiano Veneto has also made a success of its subsidiary, Caboto, and foreign banks rate Istituto San Paolo di Torino highly in certain markets.
The European investment services directive presents Italian banks with a choice as to how they should organize themselves. From 1991, in order to operate on the Italian stock market, Italian and foreign banks had to own a special securities company, or SIM. Many banks took over small family-owned stockbrokers or built their own SIMs. When the investment services directive goes into effect in Italy, bringing with it the single passport allowing securities firms approved by the regulator in one country to operate in all others - this was meant to happen EU-wide on January 1 but several countries have delayed - the need to own and operate a SIM will disappear. Italian banks will then be able to bring their equity operations back into the bank.
Those banks which do so will be making a big mistake, in the opinion of Papa at Deutsche Bank: "This should be an opportunity to build true investment banking businesses around the existing SIMs. Investment banking does not thrive within a commercial banking business. My impression is that many Italian banks are arguing internally about this. Their commercial banking culture is already too strong. The Italian financial community ought to rethink the products it offers and the way it is organized."
Public ownership
There are other problems for the Italian banks. There are too many small and unprofitable ones, and mergers and acquisitions that might bring efficiencies have been slow to happen. Outside shareholders are not powerful enough to demand better performance because the Italian banking industry largely remains in public ownership. Papa adds: "I do not see much sign of re-allocation of capital away from the old business of intermediation into new and more profitable lines of business."
Only 25% of gross revenue in the Italian banking system comes from commissions. Most of it still comes from the spread between deposits and loans. This is despite the fact that it is possible to generate a return on equity from investment banking in Italy three times greater than from commercial banking. Banking reform has not got far, despite the efforts of legislators and the Bank of Italy. The many local savings banks have been required to form holding companies owning bank operating companies; they are then supposed to sell their shares in these banking operations and redeploy the proceeds in other investments. It's a programme that has yet to start working.
Bank mergers that might create five large banks instead of 15 medium-sized ones have not been forced through. Absurdities continue. Italian banks have been opening new branches in the last five years, while banks in most other European countries have been closing them. "The Italian banking system is under strain and the whole system needs re-shaping," says Azzoni.
The Italian equity market is not big enough, nor are banks profitable enough for a large-scale privatization through public share offers. To date, privatization sales of Italian banking stocks have not been well received. The sales of shares in Banca Commerciale Italiana and of Credito Italiano did not win many plaudits, partly because of the comparatively poor performance of share prices and partly because of what they revealed about the exercise of control over publicly-quoted companies. It is widely known that through a series of Chinese boxes, one Italian company may exert control over another with only a tiny shareholding. The controlling company owns one holding company, which owns another and another which, in turn, exercises control over the target company. One Italian broker recalls a painful conversation with an American fund manager who had bought, on the Italian's recommendation, shares in Credito Italiano and Banca Commerciale Italiana. When the fund manager realized that Mediobanca managed to exert control over these banks without owning anything close to a significant shareholding, the American fund manager sold his shares and vowed never to buy another Italian stock.
The same broker admits: "As to corporate governance, we are in a state of development - from a starting point in the Stone Age. No company in Italy is really public. They all have a reference shareholder or group of shareholders who exercise control."
Some market participants see signs of improvement in mechanisms for protecting the rights of minority shareholders. Perhaps emboldened by their foreign counterparts, managers of Italian mutual funds have found their voices recently. They were openly critical of management at the annual shareholders' meeting of Montedison earlier this month.
But much progress is required to develop convincing corporate governance. Typical of the way the Italian financial system has worked to date is the way companies have funded themselves using their own severance funds. Italian companies are required to provide on their balance sheets roughly the equivalent of one month's salary for every year each employee has worked there. This money is to be paid out if employees are made redundant: something still not common in Italy. It's an obligatory saving scheme, but one which is not managed. The funds stay within the company and the employees run the risks of an equity investor in the company but without any voting rights. If pension funds in Italy develop to a size comparable with other countries - laws have recently paved the way for the creation of company-contributed pension funds - this may help further to develop corporate governance.
In the meantime, investment bankers point out that minority shareholders have suffered more at the hands of larger industrial groups than with owners and managers of more recently-listed small cap stocks. But Costamanga at Goldman Sachs sees little comfort in such claims or in the new-found aggression of Italian fund managers at AGMs. Drawing on his previous experience as a director of Montedison, he recalls that the whole basis of Italian corporate law rests on the assumption that a company has one single reference, or controlling, shareholder. "In Italy, shareholders have to approve financials in the annual report. It takes two months to issue new shares because it requires a shareholders' extraordinary meeting at 45 days' notice. All this is fine when there is a single majority shareholder, but it doesn't make sense for a public company. We won't solve this problem by standing up and making criticisms at AGMs. It requires a substantial reform of the entire civil code."
Recession fears
For the moment, foreign institutional investors seem to have set aside their fears over abuse of shareholders' rights in Italy. According to Kevin Tempestini, director of Italian equity strategy at Salomon Brothers, it is foreign investors which have driven the recent rally in Italian stocks. The behaviour of domestic investors, as measured by flows into Italian mutual funds, has been more cautious. In April, domestic equity funds saw net redemption of L90 billion and in May of L254 billion. In May domestic fund managers recorded net sales of L400 billion. These are modest amounts, no more than $300 million. But this selling provides a stark contrast to the L5 trillion that poured into domestic funds in April 1994, following the Berlusconi election victory. "Today, markets are going up, but Italians are not buying," says Tempestini. "If they are trying to buy shares in the right company, that won't matter. They may buy, but they will sell something else to do it. Selectivity is crucial in Italy right now. Foreign investors need a reason to increase their exposure, with the initial political improvement and interest rate cuts priced in."
Pricing of new issues will also be critical. Pricing has to be properly linked to earnings growth and that earnings growth has to be sustainable even with a strengthening lira. This raises some doubts for Italian markets. The Bank of Italy is the only European central bank not to have cut interest rates in the last 12 months and may do so soon. That will help a notoriously interest-sensitive market.
Meanwhile, the country fears a recession. Brokers worry that Italian consumers are not spending in the opulent Milan boutiques, real-estate prices are flat and a recent survey suggests that 60% of Italians will not renew their cars within three years. For the last three years, the north-east of the country has enjoyed enormous growth, mainly export-driven. "All the signs are that this is over," says a gloomy Azzoni. "What happens next is that some of these companies that have enjoyed such growth, may have to restructure, sack people - even go bankrupt." Tougher business conditions will provide a stern test of the new improved Italian stock market. |