While the draft legislation was pending, many Israeli business owners seemed to be adopting a ‘wait and hope’ approach, keeping fingers crossed that their businesses would be carved out of the new law’s scope. The passage of final legislation in December 2013 has engendered a new mindset at many of these businesses. We are now seeing signs of a renewed opening for financial sponsor opportunities in the market.
The number of transactions will inevitably be limited by the size of the Israeli economy, and deal activity will likely continue to be weighted towards mid-sized and smaller deals. As we discuss below, we expect these deals will be fairly bespoke, each requiring investors to deal with a specific set of challenges. Nonetheless, we believe that the new legislation and other factors will support continued growth in Israeli financial sponsor transactions, including for medium and large-scale private equity funds.
Concentration committee reforms
The law passed by Israel’s Knesset in December last year was the culmination of a three-year process that began with the establishment of a governmental committee of senior regulators charged with recommending structural reforms to the economy. Among the key provisions in the statute as enacted are some fundamental structural reforms, including prohibiting cross-ownership of significant financial and non-financial entities, limiting pyramid structures to two tiers and restricting the aggregate amount of credit an Israeli lender can offer across related companies.
The law provides for a four- to six-year phase-in period. In other words, the clock has started ticking for control shareholders who oversee the multi-sector conglomerates targeted by the law to come into compliance.
With pressure on Israeli shareholders to exit certain companies, and with cross-holding and other restrictions dampening the ability and enthusiasm of local business people from stepping into their shoes, opportunities should arise for foreign acquirers. Based in part on the other factors discussed below, we believe financial sponsors, in particular, should be well placed to take advantage of some of these opportunities.
Growing prestige of private equity in the local market
Private equity has benefited from a higher (and positive) profile in Israel over recent years. A number of factors underlie this trend, including:
- the growing local private equity scene, which includes names such as Tene, Fortissimo and Fimi, each of which has executed several successful transactions over the last few years;
- the brand recognition achieved by the likes of Apax, Permira, TPG and others with high-profile transactions, including Bezeq, Psagot and Tnuva (Apax), Netafim (Permira) and Strauss Coffee (TPG); and
- the shift by Israeli entrepreneurs and venture capital backers, especially before the recent resurgence of world capital markets, from IPO-based exits towards M&A-based exits.
Management teams and boards of directors of Israeli companies are becoming increasingly familiar with private equity transactions. Similarly, as increasing numbers of private equity funds look closely at Israel, either through local representative offices, contracted ‘finders’ or dedicated Israel teams, they are coming across opportunities that previously would have been missed and are attracting more of their peers to the market.
Ownership structures conducive to financial buyers
Certain characteristics of the Israeli economy and its common forms of corporate ownership make it well suited to private equity investment. In particular, holding structures with a single controlling shareholder facilitate the acquisition of control.
Many family-founded and operated businesses continue to be controlled by the original family – a structure somewhat similar to that frequently found among Germany’s mittelstand. Likewise, as traditional kibbutz industries have grown in recent years, they have found private equity financing to be an amenable path towards growth while maintaining organic ownership and management.
Given this framework and the features of Israeli takeover and stock exchange regulation, financial sponsors enjoy the freedom to craft transaction structures suited to the specific investment opportunity, including partnering with the current owners, continuing a public listing or taking the company private. The Israeli market boasts a highly developed legal sector familiar with private equity transactions and a fair amount of case law that looks to the Delaware Court of Chancery as a guiding light in business law cases. In most instances, when there are two willing parties, deal technology exists to get transactions completed with reasonable certainty.
An abundance of technology deals
Many commentators have predicted that private equity will demonstrate a growing appetite for technology deals, particularly in the wake of last year’s flagship going-private transaction in Dell Computers. Only time will tell if such predictions hold true, but to the extent they do, Israel’s robust technology sector makes it prime hunting ground for private equity investors.
All of this is not to say that we see only clear sailing ahead. On the contrary, as with investments into any new market, private equity players looking at Israel for the first time should bear in mind several potential pitfalls.
Many Israeli business owners harbour excessively optimistic views of the value of their businesses. In nearly every public company process in which we have acted on the buy-side, we have heard the selling shareholder insist that ‘the stock market simply doesn’t understand us’ or ‘the market is mispricing us,’ sometimes by as much as 300 per cent. And most of these shareholders genuinely believe what he or she is saying. This sort of attitude often leads to an insurmountable gap in pricing. That said, effective negotiation strategies, including building personal relationships between principals and employing appropriate deal technologies such as earnouts and other price adjustments, can sometimes overcome this challenge.
Competition from local financial buyers
Several home-grown Israeli private equity funds have exhibited considerable and sustained success and are increasingly vying for the sorts of bigger deals that would in the past primarily have been of interest to foreign funds and/or their portfolio companies. Fimi, the largest of the local players, is now investing in a fund with $850m under management and has been rumoured to be looking at transactions of considerable size. As discussed above, this factor also has a positive flip side: the increasing prominence of the local financial buyers has helped pave the way for foreign private equity funds to enter the market. In some instances, the development of these local players may provide opportunities for teaming and club deals.
Competition from strategic acquirers
As private equity professionals will be accustomed, stiff competition from strategic acquirers willing to pay more for a synergistic target can result in private equity buyers being outbid at auction. This phenomenon is no stranger to the Israeli market, where sophisticated sell-side advisers will sometimes use private equity interest as a stalking horse for strategic buyers.
We witnessed this in a transaction we were working on earlier this year, when a strategic acquirer outbid a financial sponsor by a substantial margin. One exception to this danger is that companies that operate primarily within the domestic Israeli market tend to be of less interest to large international strategic players due to the limited size of the market.
Of course, private equity investors also tend to be less interested in these kinds of targets. But occasionally, interesting domestic businesses can attract the right type of financial sponsor investor without arousing interest in strategic multinationals – eg, financial institutions, infrastructure and other local businesses that may be ripe for more adept management and/or financial restructuring.
Changing national attitude towards foreign investment
While Israel has historically been an exceptionally open market for foreign investment, there has been a rising tide, especially over the last six months of public sentiment opposed to foreign acquisition of Israeli businesses. Much of the public angst has been directed towards past and contemplated acquisitions by Chinese buyers, such as the 2011 acquisition of Makhteshim Agan Industries by ChemChina, the pending acquisition of IDB’s control stake in Clal Insurance by a consortium of investors and the contemplated acquisition of Apax’s stake in Tnuva by Bright Food. Rightly or wrongly, these concerns will likely be less prevalent in regard to acquisition bids by western private equity funds.
In addition, it bears noting that while certain factions of the Knesset have been pandering to perceived popular sentiment on this issue (including by calling a special committee hearing in February dedicated to the perceived ‘threat’ of foreign takeovers), the current government remains broadly supportive of foreign investment into Israel. There is still no equivalent of US CFIUS review – ie, for foreign acquisitions in most industries, there is no requirement for regulatory approval. While this trend bears watching, the current climate remains relatively open to foreign investment, and most deals can be accomplished with adept planning and execution. Particularly for transactions into sensitive industries, foreign investors would be well advised to incorporate public relations and governmental advice into careful deal planning.
Shareholder disagreements and the need for agreed exit planning
In our experience, many private equity investors prefer to invest into Israel with a local partner. As with any business partnership, such investment relationships will inevitably be tried and tested as the partners run their business in real time and in particular by exit events. Several recent disputes between private equity investors and their local Israeli partners highlight the importance of setting clear rules governing the shareholder relationship and providing for efficient and fair dispute resolution terms. Above all, it is critical for partners to share a relationship of trust. Moreover, not only should an investment fund seek to establish these criteria at the outset, it should monitor its co-investor relationship on an ongoing basis to ensure investment goals and exit horizons continue to be aligned.
These and other dangers – including corruption risks, Israel’s geopolitical situation and local regulatory bureaucracy – need to be taken into account by financial sponsors looking to invest in Israel.
We believe that recent trends point to growing opportunities for private equity investments in Israel, including with respect to larger deals. With these opportunities come challenges, each with its own Israeli market twist. In our experience, the most important factors in dealing with these challenges and successfully investing into Israel are finding the right local partners and advisers for the specific transaction; investing time and resources to understand the complexities, risks and potential upsides around the deal; and diligently following through on post-transaction value enhancement of the target. Deals into Israel will not be friction-free, but with these ingredients, we expect private equity investors will find rewarding opportunities.