Changing course in French waters

France is country of paradox ? simultaneously a pillar of ?Old Europe? while also determined to put forth the image of ?The New France? (entrepreneurial, dynamic and successful). Advertisements frequently published by the ?Invest in France? agency boast that a people who can produce more than 400 types of cheese must be innovative, hardworking and passionate.

Cheese and wine are not the only things aging well in France. A private equity industry that a decade ago looked weak and immature is now becoming a robust element of the economy. Over €12 billion has been raised for French private equity in the past year. Progress made in the regulatory environment there has helped France's growing private equity industry reach new heights in both capital raising and investing.

For reasons having primarily to do with French legal heritage, limited partnerships do not work very well, and especially not in the context of financial services. To bridge this gap, French authorities have developed a specific format of investment vehicles to conduct private equity and venture capital business. Most common of these is the FCPR (Fonds Commun de Placement à Risque), and the related FCPI (Fonds Commun de Placement dans l'Innovation), geared towards individuals investing in innovative businesses in return for appealing tax cuts, and the SCR (Société de Capital Risque), an evergreen vehicle with the legal characteristics of a regular corporation.

All these funds have to be managed by a fund management company governed by French law (this would be the equivalent of a general partnership) and the securities must be held by a custodian (a bank, a credit institution or an insurance company offering custodian services).

Saetosus apparatus bellis deci and deal activity targeting the country, GPs face regulatory obstacles in turning around the operations of French portfolio companies. By Shahin Vallée

While efficient vehicles to conduct transactions in France have been created, the actual conducting of transactions is not so efficient, and the ability to effect change at the portfolio level is the least efficient of all. Challenges remain for private equity practitioners in France – most notably in the turnaround of distressed companies.

To be sure, French dealmaking is on the rise. Patrick Ergot of SG Capital Europe describes an upturn in French leveraged buyout transactions as being driven by a ?liquidity hurricane.? This has been aided by the fact that LBO transactions in France take place in a particularly accommodating legal and fiscal environment. Tax rules and especially tax consolidation regimes allow interest payments on the acquisition debt to be deducted from the pre-tax profit of the target company. In addition, fairly thin capitalization rules allow these deals to be effectuated with little equity and with the concourse of shareholders' debt whose interest payments are also deductible.

Yet regulatory hurdles remain that make certain buyout transactions tricky. Strict rules over the interpretation and application of the concept of ?financial assistance? are sometimes an impediment, as these prevent a company from advancing funds or pledging its assets to a third party in view of the subscription or purchase of its own shares. This rule was initially created to prevent companies from buying themselves out. But as a consequence, LBO transactions have to circumvent those obstacles by, for example, incurring debt at the level of the target company – as opposed to a special purpose vehicle, which would provide better guarantees to creditors and offers better financing terms to the financial sponsors.

In addition, the benefit of deductible interest finds its limits with what lawyers call the Amendement Charasse. The purpose of this rule is to limit the deduction of interest payments and make them proportionate to the ownership of the promoters in the acquiring vehicle. Effectively, voting rights are used to determine ownership. Claude Rosevègue, the general counsel of Apax Partners in France, describes a recent buyout transaction in which significant voting rights were granted to the seller, who both wanted to retain control and ensure a maximum deductibility of the highly leveraged deal.

Public-to-private transactions are now fuelling dealflows in the US and across Europe but are complicated in France due to regulatory constraints. For instance, it is mandatory to own 95 percent of both voting rights and shares to be able to delist a company, while this threshold is set to 90 percent in the US and the UK. Colloquially called the ?squeeze out? of minority shareholders, this step remains a challenge in France for buyout firms, who face opposition from the very vocal lobbying efforts of the Association des Actionnaires Minoritaires.

A legislative decree enacted in February of 2005 reforms the law governing securities, introducing innovation such as hybrid securities, but more essentially it reinforces the definition of preferred shares and the nuances between different classes of shares to enable a clear separation between economic ownership and control rights.

No Chapter 11
While the regulatory environment for pursuing buyout transactions in France is improving, the ability of a financial sponsor to effect change within a portfolio company remains highly challenging.

The French legal environment creates clear hurdles for private equity funds to operate in distressed situations. In-depth restructurings are often delayed to a point of no return, dependent as they are on the infamous and lengthy plans sociaux, which sets conditions by which large numbers of employees can be dismissed. Moreover, those plans sociaux are particularly costly as it is a duty of the company to first prove that layoffs are economically necessary, and second to compensate the redundant workers with generous severance packages in addition to mandatory training and redeployment.

But the issues around plans sociaux are just a reflection of a wider concern for distressed companies and bankruptcy procedures. Even funds which have specialized in turnarounds use them cautiously. Pierre André Martel of Caravelle, a turnaround fund in France, says he has used those plans in the past, but insists that this is only one small lever for creating value. In addition to the initial cost or the length of the procedure, Martel expresses concern about legal uncertainty – such layoff plans can be challenged in court and overturned ex-post, forcing companies to either reintegrate redundant workers or compensate them with years of lost wages.

Although there are undeniably heavy and protective labor laws, France is also the first nation for temp work. Labor laws allow for dozens of short-term contracts, subsidized part-time contracts with enrolled students, and flexibility when it comes to overtime hours. In addition, the 35-hour work week has created further flexibility and has overall improved the hourly productivity of the economy.

The protection of workers' rights is enshrined in French tradition and law. For example, France has no equivalent to the protection that distressed companies can obtain under Chapter 11 of bankruptcy code in the US. Insolvency procedures are largely court-managed and leave little to no room for individual negotiation. Courts have a clear mandate to first ensure the continuity of the business and safeguard employment, and to settle liabilities last. No individual action from a creditor is likely to find a settlement as long as the insolvency procedure is pending. Although, some progress is being made to allow for a different treatment of ?new money,? which might take precedence over former creditors (even secured ones), distressed finance in France remains largely underdeveloped.

A new protection procedure (procédure de sauvegarde), inspired by Chapter 11, has been created to improve efficiency and negotiation in restructuring cases. The law, passed early in 2006, is still waiting for cases to demonstrate its practicalities but professionals remain doubtful. Alexandra Bigot, a partner with law firm Willkie Farr & Gallagher who specializes in turnarounds, paints a less optimistic picture of the new procedure. She argues that the law is falling short of its main objectives. While Chapter 11 provides all latitude to draft a plan of cession, liquidation or restructuring, the French procedure allows only for a continuity plan. The procedure is also flawed because it presupposes the conservation of the existing management and it organizes the negotiation around committees that exclude shareholders, non-bank debt holders (who are now the majority of debt providers since banks underwrite the debt and sell it almost entirely to hedge funds and CDOs) and private equity funds.

In the absence of more advanced insolvency law, French turnaounds and negotiations tend to be undertaken through ad hoc procedures agreed on by all the stakeholders.

Rosevègue from Apax Partners says he welcomes the new protection procedure but adds that ?a procedure that can take a day in the UK would still take several months in France.?

The challenges faced by distressed companies in France, notably the rigidity around bankruptcy procedures, employment and redundancy dealings, are certainly significant obstacles for private equity funds. But they also create a number of opportunities for very sophisticated investors (aided by astute lawyers) to extract great value in turnaround situations in a market where skill with distressed companies is, unlike cheese varieties, not in great abundance.