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The Cost of Capital... An Update and New
     Details on the Pepperdine Data
       National Summit for Middle Market Funds
                  October 18, 2011
           John K. Paglia, Ph.D., CFA, CPA
Dow Jones Industrial Average
       (2007 – 2011)
Dow Jones Industrial Average
       (2007 – 2011)
Dow Jones Industrial Average
       (2007 – 2011)
Agenda
• State of Financing for Privately-Held
   Businesses
• Insights from Various Segments
  – Banks
  – Asset Based Lenders
  – Mezzanine
  – Private Equity
  – Investment Bankers
  – Limited Partners
• Summary and Conclusion
Pepperdine Private Capital Markets Project
• What is cost of capital for SMEs?
• The project launched in 2007; first report in July
  2009
• We now survey 12 segments
• Certificate in Private Capital Markets (3-day
  curriculum based educational program) offered
  again in Malibu, CA November 14-16; Use
  “paglia” for discount code to get $300 off
• Reports to be available by mid-November at
  http://bschool.pepperdine.edu/privatecapital
Pepperdine Private Cost of Capital Line
         Expected Returns by Capital Providers on New Investments
                                Fall 2011
70%
                                                                                    Angel (38% ‐ 47%)
60%
                                                                          VC (28% ‐ 38%)
50%

40%
                                                            PEG (21% ‐ 26%)
30%
                                            Mezz (11% ‐ 16%)
20%                       ABL (3% ‐ 7%)
      Banks  (5 ‐ 7%)
10%

0%




                        1 quartile        Median      3 quartile    Median Spring 2011
How Are Investment Valuation Techniques
                Weighted in the Private Markets?
    60%
    50%
    40%
             29%           29%
    30%                                                              23%
    20%                                   12%          9%
    10%
     0%
                Income
                                             Public
               approach     Transaction                Asset based
                                            company                        Other
              (DCF, NPV,     approach                   approach
                                            approach
                  IRR)
Average           29%            29%            12%          9%            23%
Angel             14%            21%             8%          5%            51%
VC                15%            40%            16%          5%            23%
PEG               34%            27%            16%         12%             9%
Brokers           30%            34%             5%         13%            18%
Ibanker           34%            34%            15%         11%             6%
Appraisers        50%            20%            13%         10%             8%
Which Multiples are Used to
                           Determine the Value of a Business?
                        45%
                        40%
                        35%   33%
Weight of Use (%)




                        30%
                        25%
                                          20%
                        20%                           17%
                                                                  14%
                        15%
                        10%                                                   6%         6%         4%
                         5%
                         0%
                               Recast                                           Net
                                           EBITDA     Cash flow    Revenue                EBIT
                               EBITDA                                         income                 Other
                                           multiple    multiple    multiple              multiple
                               multiple                                       multiple
                    Average     33%             20%     17%          14%        6%            6%         4%
                    PEG         25%             30%     18%          10%        6%            6%         3%
                    Brokers     34%             15%     24%          12%        5%            4%         7%
                    Ibanker     40%             22%     13%          13%        7%            5%         3%
                    Appraisers  32%             13%     16%          21%        7%            6%         4%
Deal and Leverage Multiples
                             8
                                                                                             7.0
                             7                                                  6.5
                                                                    6.0
                                                       5.5
      Multiple of EBITDA


                             6
                             5             4.5
                                 4.0
                             4                                                  4.8          5.0
                                                                    4.5
                             3                         4.0
                                 3.5       3.5
                             2                                      3.0         3.0          3.0
                                 2.3       2.3         2.5
                             1
                             0
                       $1M               $5M         $10M         $25M         $50M       $100M
                      EBITDA            EBITDA      EBITDA       EBITDA       EBITDA      EBITDA
      Deal multiples     4                4.5         5.5           6            6.5         7
      Senior leverage 2.25               2.25         2.5           3             3          3
      Total leverage    3.5               3.5          4           4.5          4.75         5

Source: Pepperdine Private Capital Markets Project Fall 2011 Business Owner Survey, Pepperdine University
What is the Status of
Privately-Held Businesses
     as of Fall 2011?
Businesses: Today vs. 6-Months Ago
• Significant increases in prices of labor and
  materials
• Increases in unit sales, net income,
  opportunities for growth
• Receivables periods lengthening
• General business conditions declining while
  significant increase in time worrying about
  economy
What is the State of Financing?

   • Nearly 91% of business owners report having
     the enthusiasm to execute growth strategies
   • Yet just 49% report having the necessary
     financial resources to successfully execute
     growth strategies




Source: Pepperdine Private Capital Markets Project Fall 2011 Business Owner Survey, Pepperdine University
Top Issues Facing
                      Privately–Held Businesses
                                                               Economic uncertainty (domestic)

             2% 2%                                             Access to capital
       3%
                          5%
                                             38%               Government regulations and taxes
     25%
                                                               Inflation

                           26%                                 Economic uncertainty
                                                               (international)
                                                               Competition from foreign trade
                                                               partners
                                                               Other

Source: Pepperdine Private Capital Markets Project Fall 2011 Business Owner Survey, Pepperdine University
Business Owners’ Current Sources of
                          Financing (All sizes)
                60%

                50%    47%
Frequency (%)




                40%
                             30%
                30%
                                   19% 19%
                20%

                10%                                                             8%
                                             3%   3%   2%   1%   1% 0.3% 0.3%
                 0%

                ‐10%
Business Owners’ Current Sources of
        Financing (>$5 million revenues)

60%
       53%
50%

40%          38%

30%

20%                16%
                         8%   9%                                 9%
10%                                     5%
                                   3%        2%   2% 1.4% 0.5%
0%
Business Owners’ Estimates of
                              Cost of Equity (by Revenue Size)
                     25%
                                 23%
                                           19%
                     20%                               19%
                                 17%                               17%
Cost of Equity (%)




                                           15%        15%                      15%
                     15%                                                                 15%        14%      14%
                                                               15%
                                                                           13%         13%
                     10%
                                                                                                   11%        11%

                     5%


                     0%
                           Less than $1 million ‐ $5million ‐ $10 million $25 million $50 million $100 ‐ $500 Greater
                           $1 million $5 million $10 million ‐ $25million ‐ $50         ‐ $100      million than $500
                                                                            million     million               million
                                                            Mean      Median
Small Business Financing Success Rates
            For Twelve Month Period Ended September 16, 2011
          100%
                           94%        91%             90%
           90%       83%
                                                                    79% 77%
           80%                                                                          74%
           70%                                67%
           60%                                                                   57%
           50%                                                                                45%
                                                             40%
           40%
           30%
           20%
           10%
            0%
                                     Credit
                    Avg.   Friends          Factor   Bank   Angel   ABL   Mezz. Hedge   PEG   VC
                                      card
Less than $5M       51%     78%       63%    47%     44%    41%     38%   25%   23%     23%   20%
$5M ‐ $25M          64%     90%       85%    58%     72%    25%     61%   25%    8%     44%   30%
Greater than $25M   83%     94%       91%    67%     90%    40%     79%   77%   57%     74%   45%
Persistence Pays…
          Average Number of Capital Providers Contacted for
                   Successful Financing Outcome
6.0
                     5.3
5.0
                               4.8
                                         4.0
4.0                                                3.6        3.4
           3.2
3.0                                                                    2.4      2.4        2.3       2.3      2.0
2.0

1.0

0.0




      Source: Pepperdine Private Capital Markets Project Fall 2011 Business Owner Survey, Pepperdine University
Business Owners’ Expected Time to Exit
                         (>$5 million revenues)
                  0.3
                                                                        25%
                 0.25                                                                         23%

                  0.2
Percentage (%)




                                    About 30% within                            16%
                 0.15                next five years
                                                                11%
                  0.1
                                         5%      6%                                    6%
                 0.05
                          3%                             3%
                                 2%
                   0
                        < 1 year 1 year 2 years 3 years 4 years 5 years 5‐10    10‐15 15‐20    >20
                                                                        years   years years   years
Businesses with Revenues >$5M:
           The Next 12 Months
• Significant increases in unit sales along with
  product/service pricing and prices of labor and
  materials increases
• Increases in net income, opportunities for growth
• Receivables periods lengthening
• No improvement in general business conditions
  and further increase in time worrying about
  economy
What’s Happening with
 Capital Providers?
Banks: Today vs. 6-Months Ago
• Worsened business conditions and appetite for
  risk
• Demand for loans and underwriting standards
  flat (despite more due diligence) with slight
  increase in credit quality of borrowers
• Increased focus on collateral as backup means
  of payment; personal guarantee coverage flat,
  but starts to burn off around $5 million in loan
  size
• Highly competitive for quality companies; pricing
  and loan structures back to pre-crash levels
Banks: Loan Sizes Underwritten
60%
                     51%
50%

                                              40%
40%                               36%
                                                         29%
30%                                                                  25%
          24%
20%

10%

0%
      Less than $1M $1M ‐ 5M   $6M ‐ $10M $11M ‐ 25M $25M ‐ $50M Greater than
                                                                    $50M

Largest concentrations of loan sizes were between $1 million
and $25 million
Banks: Motivations for Loans

                                      Refinancing existing loans or 
           5% 4%                      equity
                                      Expansion
         10%
                         49%
   11%
                                      Working capital fluctuations

         22%                          Management buy‐out

                                      Finance worsening operating 
                                      conditions
                                      Other



Refinancing accounted for nearly 49% of all lending activity
followed by expansion (22%), working capital (11%)
Banks: Increased Pressure from Regulators to
         Avoid Making Risky Loans?


                       13%    4%



                                                                 Agree
                                         82%                     Neutral
                                                                 Disagree




    Banks declined 63% of cash flow based loans over prior six
    months
Banks: Senior Leverage Multiples
          for Business Services Companies
               1st Quartile              Median            3rd Quartile  
            Spring                Spring                 Spring 
 EBITDA               Fall 2011              Fall 2011             Fall 2011
             2011                  2011                   2011
 $1M         1.2         1.3       1.2          1.5       1.9        2.0
 $5M         2.5         1.4       2.5          2.0       3.0        2.4
 $10M        2.5         2.4       2.5          2.5       3.0        3.0
 $25M        2.5         2.4       3.0          2.5       3.0        3.0
 $50M        2.6         2.5       3.0          3.0       3.0        3.3
 $50M        3.1         2.6       3.3          3.0       3.4        3.4

Approximately 1.5X – 2.5X under $25M in EBITDA; 3X and
above greater than $25M
Banks: Senior Leverage Multiples
            for Manufacturing Companies
                1st Quartile              Median            3rd Quartile  
             Spring                Spring                 Spring 
EBITDA                 Fall 2011              Fall 2011             Fall 2011
              2011                  2011                   2011
 $1M          1.3         1.5       1.3          1.8       2.0        2.0
 $5M          2.1         1.5       2.5          1.8       3.0        2.1
 $10M         2.4         2.3       2.5          2.5       3.0        2.8
 $25M         2.6         2.4       3.0          2.5       3.0        3.0
 $50M         2.5         2.5       3.0          3.0       3.0        3.3
 $100M        2.3         2.7       3.0          3.3       3.2        3.5


Approximately 1.8X – 2.5X under $25M in EBITDA; 2.5X and
above greater than $25M
Banks: All in Rates on Cash Flow Loans (%)
                   1st Quartile             Median             3rd Quartile 
               Spring                 Spring                Spring 
EBITDA                    Fall 2011             Fall 2011            Fall 2011
                2011                   2011                  2011
$1 million       5.4         5.5        6.5        7.0        7.1       7.0
$5 million      5.0         5.8        5.5        6.0        6.0        6.0
$10 million     4.5         5.0        5.5        5.5        7.0        5.5
$25 million     3.8         4.8        5.5        5.5        7.2        6.5
$50 million     3.5         3.8        5.0        4.0        7.4        6.5


Rates correspond to loan terms of 60 months (median)

Slight increase in all-in-rates on cash flow loans over the last
6 months, except for large companies
Banks: Financial Evaluation Metrics (Medians)
                                     Average                       Importance 
                                                  Approval Limits 
                                    Borrower                        Score (0‐4)  
                                 Spring  Fall      Spring  Fall  Spring  Fall 
                                  2011    2011 2011 2011 2011 2011
  Current ratio                    1.4     1.4      1.3     1.1    1.7      1.6
  Total debt service coverage 
                                  1.3      1.3      1.3     1.2     3.7     3.5
  ratio
  Total debt to cash flow         2.5      2.8      2.8     4.0     3.2     3.0
  Debt to net worth               2.0      2.0      2.4     3.0     2.5     2.2

  Approval thresholds in Fall 2011 are lower than in Spring 2011
  but average borrower characteristics are relatively constant
Banks: The Next 12 Months
• Sharp increase in demand for loans, lending
  capacity of banks and SBA lending
• Underwriting standards and credit quality of
  borrowers relatively flat
• Further increases (slight) in senior/total
  leverage multiples
• Relatively flat business conditions
• Increasing due diligence efforts and further
  pricing compression
What’s Happening with
Asset Based Lenders?
ABLs: Today vs. 6-Months Ago
• Increased demand for loans
• Slight increase in standard advance rates on
  collateral
• Compressed loan fees and spreads
• Increase in loans outstanding
• Slight decline in business conditions
ABLs: Loan Sizes Underwritten
60%

50%             48%

40%

30%                      28%               28%
                                  24%
20%    16%                                          16%      16%

10%                                                                   8%

 0%
      Less than $1M ‐ 5M $5M ‐   $10M ‐   $25M ‐   $50M ‐   $100M ‐ Greater
        $1M              $10M     25M      $50M    $100M     $500M   than
                                                                    $500M

Largest concentrations of loan sizes were between $1 and $5
million (48%)
ABLs: Motivations

                                      Refinancing
                5%
          13%                         Finance worsening operations 
    13%                               conditions
                          55%
                                      Fluctuating working capital
       17%

                                      Expansion

                                      Other



Refinancing accounted for nearly 55% of all lending activity
followed by worsening operations conditions (13%) and
working capital (13%)
ABLs: Advance Rates

                            Typical Loan  (Median %) Upper Limit (Median %) 
                              Spring 
                                        Fall 2011 Spring 2011 Fall 2011
                               2011
Marketable securities           80          90           90          90
Accounts Receivable            80           85           85          85
Inventory ‐ Low quality        25           25           40          30
Inventory ‐ Intermediate 
                               40           45           50          50
quality
Inventory ‐ High quality       55           60           60          60
Equipment                      60           75           80          75
Real Estate                    60           65           70          70
Land                           50           40           50          42

On average, advance rates are slightly higher than 6
months ago
ABLs: Collateral Valuation Standards
                           0%   10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

          Purchase price          10%

                                6%
Depreciated Value (Book)

             Face value                          35%

       Fair Market Value                                                         87%

      Forced Liquidation
                                               33%
                                                                 63%
     Orderly Liquidation
                                                       44%
                  Other


                  Equipment      Real estate   Accounts Receivable   Inventory
ABLs: All in Rates (%)
Type and Size          1st Quartile       Median        3rd Quartile 
                     Spring  Fall      Spring  Fall    Spring  Fall 
                      2011 2011         2011 2011       2011 2011
WORKING CAPITAL
$5M                   5.0      6.8      7.0     9.3    11.0     12.0
$25M                  3.0      3.8      3.4     4.9    4.4      10.5
$50M                  3.0      2.8      3.3     3.0    4.0      3.3
$100M                 2.6      2.5      3.0     2.8    3.4      3.1
EQUIPMENT
$5M                   5.3      5.5      7.3     6.5     8.9     6.5
$25M                  3.9      3.4      5.8     3.6     7.1     3.9
$50M                  3.5      2.6      4.0     2.8     5.6     3.1
$100M                 3.4      2.5      4.0     2.5     4.6     2.5

All-in-rates are lower than 6 months ago except small
size lending with working capital as a collateral
ABLs: Financial Evaluation Metrics (Medians)
                              Average       Approval       Importance 
                             Borrower        Limits         Score (0‐4) 
                            Spring  Fall  Spring  Fall    Spring  Fall 
                             2011 2011 2011 2011           2011 2011
  Current ratio              1.0    1.7    1.0     1.2     1.1      0.9
  Total debt service 
                             1.2    1.1    1.0     1.0     2.6      2.4
  coverage ratio 
  Total debt to cash flow    3.5    3.0    3.8     4.0     2.4      2.3
  Debt to net worth          2.1    2.8    2.5     2.7     2.1      1.7
  Revenue growth rate       1.1%   5.0%   1.0%    5.0%     1.5      1.8
ABLs: The Next 12 Months
• Sharp increase in demand for loans and
  loans outstanding
• Underwriting standards slightly more
  stringent but credit quality of borrowers will
  continue to improve
• See business conditions generally flat
• Relatively flat pricing
What’s Happening with
 Mezzanine Capital?
Mezzanine: Today vs. 6-Months Ago
• Demand for mezzanine financing up
• Increased credit quality of borrowers
• Warrant coverage down, deal and leverage
  multiples up, expected returns down with more
  competition
• Time to exit investments slightly longer
• Underwriting standards relatively flat
• Significant decrease in general business
  conditions
Mezzanine: Loan Sizes Underwritten
70%

60%                       58%

50%
                 39%                37%
40%

30%

20%                                            18%
                                                        10%
10%     6%                                                        5%
0%
      Less than $1M ‐ 5M $5M ‐$10M$10M ‐25M   $25M ‐   $50M ‐   $100M ‐
        $1M                                    $50M    $100M     $500M

Largest concentrations of loan sizes were between $5 and $10
million (58%)
Mezzanine: Loan Motivations
                                    Acquisition loan
           5%   2%
                                    Management buyout
     15%               29%
                                    Refinancing
  15%
                     28%            Financing growth

                                    Working capital fluctuations

                                    Finance worsening operations 
                                    conditions

Acquisition loan investments accounted for 29% of activity,
followed by MBO (28%), refinancing (15%) and growth (15%)
Mezzanine: To Make One Investment…
70
             60
60

50
        40
40

30

20
                           15
                      10
10                                    6     8
                                                     2         2
 0
     Plans Reviewed   Meetings    Proposal Letters       LOI

                        Median   Average
Mezzanine: Interest Rates (%)
                 Sponsor Transactions

                 1st Quartile (%)      Median (%)        3rd Quartile (%)

                 Spring              Spring              Spring 
EBITDA Size              Fall 2011           Fall 2011           Fall 2011
                  2011                2011                2011
$1M                12        12        13        12        14        13
$5M                12        12        13        12        13        13
$10M               12        11        13        12        13        12
$25M               12        10        12        11        12        12
$50M                         10                  11                  12
$100M                         7                  11                  12


 Mezzanine interest rates for sponsor transactions are
 lower than 6 months ago
Mezzanine: PIK (%)
              Sponsor Transactions
              1st Quartile (%)      Median (%)        3rd Quartile (%)
              Spring              Spring              Spring 
EBITDA Size           Fall 2011           Fall 2011           Fall 2011
               2011                2011                2011
$1M             3          1        4          1        4          2
$5M             2          1        3          3        4          3
$25M            3          3        3          4        3          4
$50M                       4                   4                   4
Mezzanine: Total Expected Returns (%)
          Sponsor Transactions
               1st Quartile (%)     Median (%)        3rd Quartile (%)
              Spring              Spring              Spring 
EBITDA Size           Fall 2011           Fall 2011           Fall 2011
               2011                2011                2011
$1M             18        16        20        20        22        21
$5M             18        19        20        20        22        26
$10M            17        15        19        18        20        20
$25M            18        12        19        16        19        20
$50M                      13                  14                  15
$100M                      7                  13                  16


 Mezzanine total returns decreased for $10 million and $25
 million loans in the last 6 months
Mezzanine: Interest Rates (%)
         Non-Sponsor Transactions
             1st Quartile (%)      Median (%)          3rd Quartile (%)
             Spring              Spring                Spring 
                     Fall 2011             Fall 2011             Fall 2011
              2011                2011                  2011
$1M            13        10        14         12         14         14
$5M            12        12        14         12         14         14
$10M           12        12        12         12         13         14
$25M           12        10        12         12         13         13



Mezzanine interest rates for non-sponsor transactions are
slightly lower than 6 months ago
Mezzanine: PIK (%)
        Non-Sponsor Transactions

         1st Quartile (%)      Median  (%)       3rd Quartile (%)
         Spring              Spring              Spring 
                 Fall 2011           Fall 2011           Fall 2011
          2011                2011                2011
$1M         2         2        2          2        2          2
$5M         1         2        2          2        2          2
$25M        3         2        3          3        3          3
$50M                  2                   3                   3


          Relatively constant percentages
Mezzanine: Total Expected Returns (%)
      Non-Sponsor Transactions

             1st Quartile (%)     Median (%)        3rd Quartile (%)
            Spring              Spring              Spring 
                    Fall 2011           Fall 2011           Fall 2011
             2011                2011                2011
$1M           23        17        24        19        25        20
$5M           22        20        22        19        24        25
$10M          20        16        20        18        21        25
$25M          18        15        18        17        19        21




Mezzanine total returns decreased for almost all loan sizes
in the last 6 months
Mezzanine: Total Leverage Ratios
               1st Quartile (%)   Median (%)    3rd Quartile (%)
               Spring           Spring           Spring   Fall
                      Fall 2011        Fall 2011
                2011             2011             2011    2011
$1M             2.9       3.0     3.5     3.5     4.1      3.5
$5M             3.5       3.0     3.5     3.5     4.0      4.0
$10M            3.5       3.5     4.0     4.0     4.0      4.5
$25M            4.4       4.0     4.8     4.5     5.0      5.0
$50M                      4.0             4.8              5.0
$100M                     5.0             5.0              5.5


Represents additional 1 – 2 turns of EBITDA (after senior),
increasing with size. Relatively constant when compared to
Spring 2011.
Mezzanine: Time to Exit (Months)
                   1st Quartile        Median        3rd Quartile
                  Spring   Fall     Spring   Fall   Spring   Fall
                   2011    2011      2011    2011    2011    2011
$1M                36          60    48      60      63       60
$5M                48          60    54      60      60       60
$10M               48          60    60      66      60       72
$25M               33          60    36      60      42       72
$50M                           60            72               78
$100M                          72            78               84


Looking to exit in 5-7 years

Exit times are longer than 6 months ago
Mezzanine: Financial Evaluation Metrics
              (Medians)
                               Average         Approval        Importance 
                              Borrower           Limits         Score (0‐4) 
                            Spring  Fall     Spring  Fall     Spring  Fall    
                             2011 2011 2011 2011 2011 2011
Senior debt service 
                             1.6      1.5     1.3      1.2     3.3      2.4
coverage ratio 
Total debt service 
                             1.3      1.4     1.2      1.2     2.7      3.3
coverage ratio 
Senior debt to cash flow     2.5      2.5     3.0      3.0     3.4      2.9

Total debt to cash flow      3.5      4.0     4.0      4.0     3.4      3.6
Mezzanine Investments: Transactions in
             Next 12 Months
                                             0 to 2

              11%   7%                       3  to 5
       13%
                             39%
                                             6 to 10
        32%
                                             11 to 15

                                             more than 15



Largest concentration of responses indicates plan for 3 – 5
transactions in next 12 months (39%); 32% are planning
between 6 and 10
Mezzanine Investments: Segments Targeted
            in Next 12 Months
                                      Business Services
              2% 3%
                                      Manufacturing
              8%         22%
         8%                           Health Care
   10%                                Retail and Consumer Services
                               21%
       12%                            Wholesale & Distribution
                   14%                Information Technology
                                      Basic Materials & Energy
                                      Financial Services
                                      Other

Business services (22%), manufacturing (21%), and
healthcare (14%) look to be areas targeted for investment
Mezzanine: A View to the Next 12 Months
• Increasing demand for mezzanine capital, but
  flat leverage multiples
• Slight increase in underwriting standards
• Relatively flat loan fees, PIK, and warrant
  coverage
• Significant decrease in general business
  conditions
• Increasing size of mezzanine industry with
  additional competition from business
  development companies (BDCs) and SBIC
  funds
What’s Happening with
   Private Equity?
Private Equity: Today versus 6 Months Ago

 • Increased demand for private equity and
   increases in quality of companies
 • Increased deal multiples, exit times longer
 • Increased amount of non-control
   investments
 • Decrease in expected returns on new
   investments and lower appetite for risk
 • Worsened general business conditions
Private Equity: Investment Activity
              in Last Six Months
              4%   4%                          0
         7%
                        26%                    1
        11%
                                               2
        17%                                    3
                        31%
                                               4
                                               5
                                               more than 5



Nearly 74% of respondents reported making a deal in the last
6 months; approximately 26% reported no transactions
Private Equity: Investment Checks Written
 40%
                                        35%
 35%                          33%                  33%
                    30%
 30%
 25%
 20%                                                        18%
                                                                      16%
 15%
 10%      8%
 5%                                                                             3%
 0%
       Less than     $1‐5     $5‐$10    $10‐25    $25‐$50 $50‐$100 $100‐$500 Greater
       $1 million   million   million   million    million million   million than $500
                                                                               million

The largest concentration of checks written was in the $10 -
$25 million range (35%) followed by $25 - $50 million (33%)
and $5 - $10 million (33%)
Private Equity: To Make One Investment…
160
              142
140
120
        100
100
 80
 60
 40
                              22
 20                    15
                                         5     9
                                                        2         2
 0
      Plans Reviewed   Meetings      Proposal Letters       LOI

                            Median   Average
Private Equity Balance of Capital with
                      Businesses Worthy of Financing:
                            Surplus or Shortage?
                  1.2

                                                                               0.7    0.7
                  0.7                                        0.5      0.6
                          Relative                  0.3
Score (‐2 to 2)




                  0.2     Shortage         0.1

                  ‐0.3

                                  ‐0.6
                  ‐0.8
                         ‐0.9
                  ‐1.3
                         $1M      $5M      $10M     $15M     $25M     $50M    $100M > $100M
                        EBITDA   EBITDA   EBITDA   EBITDA   EBITDA   EBITDA   EBITDA EBITDA
                  Score ‐0.9      ‐0.6      0.1      0.3      0.5      0.6      0.7    0.7
Private Equity: Difficulty Securing
                                   Senior Debt?
                   3.0

                   2.5                                                         2.3

                   2.0                              1.8               1.7
                                                             1.7
Score (‐3 to 3)




                   1.5                     1.3
                   1.0

                   0.5            0.4

                   0.0

                  ‐0.5
                          ‐0.5
                  ‐1.0
                         $1M      $5M      $10M     $15M     $25M     $50M    $100M+
                        EBITDA   EBITDA   EBITDA   EBITDA   EBITDA   EBITDA   EBITDA
                  Score  ‐0.5      0.4      1.3      1.8      1.7      1.7      2.3
Private Equity: Deal Multiples (of EBITDA)

EBITDA        1st Quartile            Median              3rd Quartile  
           Spring                Spring                Spring 
                     Fall 2011             Fall 2011             Fall 2011
            2011                  2011                  2011
$1M          3.9         3.0       4.0       4.0         5.3        5.5
$5M          4.5         3.5       5.0       4.5         5.7        6.0
$10M         5.0         4.5       6.0       5.5         7.0        7.0
$25M         5.5         5.0       6.0       6.0         7.8        7.5
$50M         7.5         5.0       7.5       6.5         8.0        8.5



Median deal multiples starting to exhibit weakness
Private Equity: Equity Contributions (%)

EBITDA     1st Quartile (%)         Median (%)         3rd Quartile (%)

           Spring                Spring                Spring 
                     Fall 2011             Fall 2011             Fall 2011
            2011                  2011                  2011
$1M         39          45        60          60        83          95
$5M         40          45        60          55        70          85
$10M        50          38        58          50        62          55
$25M        25          35        48          45        60          53
$50M        21          25        33          35        40          35
$100M       10          35        20          35        23          55



Median equity contributions reported range from a high of 60%
for smaller transactions to 35% for larger companies
Private Equity: Expected Returns (%)
EBITDA      1st Quartile (%)        Median (%)         3rd Quartile (%)
           Spring                Spring               Spring 
                     Fall 2011            Fall 2011             Fall 2011
            2011                  2011                 2011
$1M          25          25        30         30        35          38
$5M         25          23        30         25        30          35
$10M        25          23        30         25        31          30
$25M        25          23        28         25        30          30
$50M        22          23        25         25        30          30
$100M                   23                   25                    27
$500M                   21                   23                    27

Expected gross annual returns on new investment range from a
median of 25% for most large transactions to 30% for smaller
ones
Expected returns are significantly lower than 6 months ago
Private Equity: Exit Times (Months)
EBITDA        1st Quartile             Median            3rd Quartile
           Spring                Spring                Spring 
                     Fall 2011             Fall 2011             Fall 2011
            2011                  2011                  2011
$1M         48          48        60             60     60          60
$5M         48          48        60             60     60          60
$10M        36          46        48             60     48          60
$25M        37          40        48             48     60          51
$50M        48          30        48             48     60          48
$100M       48          48        48             48     48          60
$500M                   48                       48                 60

Expected exit times range from 48 months for larger
transactions to 60 months for smaller ones
Private Equity Investing: Number of
         Transactions in Next 12 Months
                                       0
                       2%
       5%                              1
 6%               8%        9%
                                       2
  9%
                                 30%
                                       3
            30%                        4

                                       5

                                       6

                                       more than 6



60% are looking to make 2 – 3 investments in the next year
Private Equity Investing: Segments Targeted
             in Next 12 Months
                                       Manufacturing
     6%                                Business Services
               13%   19%
6%                                     Health Care
     7%                     16%        Retail & Consumer Services
          9%                           Basic Materials & Energy
               12%    12%
                                       Wholesale & Distribution
                                       Financial Services
                                       Information Technology
                                       Other


Manufacturing (19%), business services (16%), healthcare
(12%), and retail & consumer services (12%) appear to be the
targets of 59% of investments
Private Equity: A 12-Month View
• Increasing demand for private equity and
  quality of companies seeking investment
• Increasing amount of non-control investments
• Deal multiples increasing further
• Generally flat to slightly lower expected
  returns on new investments
• Worsening general business conditions and
  lower appetite for risk
What are Investment
Bankers Experiencing?
Investment Bankers: Today vs.
               6-Months Ago
• Deal flow up slightly
• Relatively flat leverage and deal multiples
• Extended time / increased difficulty to sell
  business
• Increased presence of strategic buyers
• Increased margin pressure on companies
• Worsened business conditions
Investment Banks: Business Sales
          Transactions in Last 6 Months
                                       0
                                       1
 6%     6%3%   9%   25%
                                       2
   7%                                  3
         20%          24%              4
                                       5
                                       6
                                       more than 6


75% report making at least one deal in last 6 months; 51% made
between 1 – 3 while 25% didn’t make any
Investment Banks: Time to Transact
        Businesses in Last 6 Months
                  4%
                                         2 ‐ 4 months
             9%        7%
                             22%         4 ‐ 6 months
      16%
                                         6 ‐ 8 months
      13%                                8 ‐ 10 months
                       29%
                                         10 ‐ 12 months
                                         12 ‐ 18 months
                                         more than 18 months



The largest concentration of transactions closed in 6-8 months
(29%); another 22% closed in 4-6 months
Investment Bankers: Percentage
                33.5%
                               of Deals with …
                33.0%        32.8%

                32.5%

                32.0%
                                              31.9%
Frequency (%)




                31.5%
                                                              31.1%
                31.0%
                                                                               30.7%
                30.5%

                30.0%

                29.5%

                29.0%
                        Seller Financing /   Contingent   Adjusted amount Lowered multiple
                           Seller Note        earnout      of equity  sold   of EBITDA
Investment Banks: Are Strategics
        Outbidding Financial Buyers?

                                         No
 3% 2%      13%   19%                    Yes, 0‐10% more
    13%
                         23%             Yes, 11‐20% more
                                         Yes, 21‐30% more
          28%
                                         Yes, 31‐40% more
                                         Yes, 41‐50% more
                                         Yes, >50% more


Roughly 19% report that strategic buyers didn’t pay premiums
relative to financials’ offers; 23% report premiums less than
10% and another 28% report premiums between 11-20%
Investment Banks: 43% of Engagements
     Expired Without Transaction! Why?
                                   Valuation gap in pricing
                                   Economic uncertainty
 8%     6% 6% 2%
                   29%             Unreasonable seller or buyer demand
  14%                              Lack of capital to finance
                     18%           No market for business
          17%
                                   Other
                                   Insufficient cash flow
                                   Seller misrepresentations


37% report valuation gap of less than 20%; 39% report
21 – 30% valuation gap
Investment Bankers: Difficulty
                  2.5
                             Securing Senior Debt?
                                                                      1.9       2.0
                  2.0
                                                             1.6
                  1.5                                1.3
Score (‐3 to 3)




                                            1.1
                  1.0
                                  0.4
                  0.5

                  0.0

                  ‐0.5

                  ‐1.0   ‐0.9
                  ‐1.5
                     $1M         $5M      $10M     $15M     $25M     $50M    $100M+
                    EBITDA      EBITDA   EBITDA   EBITDA   EBITDA   EBITDA   EBITDA
          PEGs       ‐0.5         0.4      1.3      1.8      1.7      1.7      2.3
          I‐Bankers  ‐0.9         0.4      1.1      1.3      1.6      1.9      2.0
Investment Bankers: Balance of Capital with
         Businesses Worthy of Financing:
     1.5
              Surplus or Shortage?
                  1.0                                                          0.8    0.9
                                                                      0.7
Score (‐2 to 2)




                  0.5                                         0.3
                                                     0.1
                  0.0
                                           ‐0.1
                  ‐0.5
                                  ‐0.6
                  ‐1.0
                         ‐1.0
                  ‐1.5
                    $1M          $5M      $10M     $15M     $25M     $50M    $100M > $100M
                   EBITDA       EBITDA   EBITDA   EBITDA   EBITDA   EBITDA   EBITDA EBITDA
          PEGs      ‐0.9         ‐0.6       0.1     0.3      0.5      0.6      0.7    0.7
          I‐Bankers ‐1.0         ‐0.6      ‐0.1     0.1      0.3      0.7      0.8    0.9
Investment Banks: Next 12-Months
            Transactions Forecast

                    2%
                                               0
                   7% 7%   13%                 1
             12%
                                               2
       16%                       23%           3
                   20%                         4
                                               5
                                               6
                                               more than 6


Almost half (48%) report an expectation to transact between
3 and 5 businesses during the next 12 months
Investment Banks: The Next 12 Months

• See deal flow up sharply
• Relatively flat leverage and deal multiples
• Extended time / slightly increased difficulty to
  sell business
• Increased presence of strategic buyers
• Increased margin pressure on companies
• Worsening business conditions
What’s Happening with
 Limited Partners?
What about the Limited Partners (LPs)?
• Compared to six months ago...
  – Allocations to VC, Mezz, Hedge, Secondaries
    down slightly
  – Allocation to PE up slightly
  – Direct investments are up
  – Business conditions down but expected
    returns on new investment up
Limited Partners: Strategy with Best Risk
         and Return Trade-off?
25%

      20%
20%         19%

15%               13%
                        11%
10%
                              7%   7%   7%
                                             6%   6%
5%                                                     4%

0%
Industry Segments with Best Risk and
                                      Return Tradeoffs
                             0.6

                                   48%
Frequency of Response (%)



                             0.5

                             0.4         36%   34%
                                                     30%
                             0.3
                                                           24%
                             0.2
                                                                 12%   10%    10%
                             0.1                                                    8%

                              0




                                                                             86
Limited Partners’ Return Expectations on
                                       New Investments (%)
                              25.0

                                      20     20        20
                              20.0
                                                                18      18
Gross expected returns (%)




                                                                                 15       15     15      15
                              15.0
                                                                                                                13

                              10.0


                               5.0


                               0.0
                                                        PE ‐     PE ‐    PE ‐    Second                   Real Fund of
                                       VC    Directs                                      Mezz   Hedge
                                                       Buyout   Grow    Distr.      .                    Estate Funds
                             Median   20.0    20.0      20.0    18.0    18.0      15.0    15.0   15.0     15.0   12.5
                             Mean     21.0    20.4      19.3    19.4    17.4      17.4    13.1   13.1     14.3   12.5
Importance of Factors When Raising Funds
                          5
                               4.5        4.4
                                                       4.0
                          4
Importance Factor (1‐5)




                                                                    3.5         3.5          3.3         3.2
                          3


                          2


                          1


                          0
                              General   Specific   Hist. Perf. all Returned     Residual  Gut feel /   Specific
                              partner   strategy      Funds       capital from value of    Instinct    location
                                                                  most recent most recent
                                                                   fund (DPI) fund (RVPI)
LPs: The Next 12 Months

• Increasing allocations to alternative assets
• See best domestic opportunities in
  California, Texas, New England states
• Allocations to various strategies relatively
  flat, but direct investments up
• Business conditions and expected returns
  up slightly
Conclusions
• Deteriorated business conditions across all
  segments surveyed; no significant improvements
  expected in next 12 months
• Starting to see early signs of leverage / valuation
  stagnation (and decline), accompanied with
  higher pricing, particularly for smaller businesses
• Extremely competitive conditions for quality large
  companies
• Capital intensive businesses appear to be eligible
  for more favorable loan pricing (ABL) and are
  likely to continue with extended economic
  weakness
Conclusions (Cont’d)
• Expected returns on new investments declining
  with longer exit times; more competition
• Opportunities appear to exist for investments in
  smaller businesses (< $10M EBITDA); debt
  more available than it was six months ago in
  $5M EBITDA segment
• See increased opportunities for working capital
  funding with receivables extending, inventories
  building, and margins compressing
• Expected continued demand for all capital types
• Invest cautiously
A True Win-Win…
               Top Policy Actions for Job Growth in 2012
              According to 10,644 Small Business Owners

                                                                      Increased access to capital
   3.8%
                    12.0%
7.9%                                     34.8%                        Tax incentives

                                                                      Regulatory reform
       18.3%
                               23.2%                                  Increased competitiveness with
                                                                      foreign trade partners
                                                                      Education reform

                                                                      Other


   Source: Pepperdine Private Capital Markets Project Fall 2011 Business Owner Survey, Pepperdine University
Thank You!
       John K. Paglia, Ph.D., CFA, CPA
        Associate Professor of Finance
Senior Researcher, Pepperdine Private Capital
                Markets Project
    bschool.pepperdine.edu/privatecapital
         john.paglia@pepperdine.edu

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Pepperdine cost of capital national summit 10 18 2011

  • 1. The Cost of Capital... An Update and New Details on the Pepperdine Data National Summit for Middle Market Funds October 18, 2011 John K. Paglia, Ph.D., CFA, CPA
  • 2. Dow Jones Industrial Average (2007 – 2011)
  • 3. Dow Jones Industrial Average (2007 – 2011)
  • 4. Dow Jones Industrial Average (2007 – 2011)
  • 5. Agenda • State of Financing for Privately-Held Businesses • Insights from Various Segments – Banks – Asset Based Lenders – Mezzanine – Private Equity – Investment Bankers – Limited Partners • Summary and Conclusion
  • 6. Pepperdine Private Capital Markets Project • What is cost of capital for SMEs? • The project launched in 2007; first report in July 2009 • We now survey 12 segments • Certificate in Private Capital Markets (3-day curriculum based educational program) offered again in Malibu, CA November 14-16; Use “paglia” for discount code to get $300 off • Reports to be available by mid-November at http://bschool.pepperdine.edu/privatecapital
  • 7. Pepperdine Private Cost of Capital Line Expected Returns by Capital Providers on New Investments Fall 2011 70% Angel (38% ‐ 47%) 60% VC (28% ‐ 38%) 50% 40% PEG (21% ‐ 26%) 30% Mezz (11% ‐ 16%) 20% ABL (3% ‐ 7%) Banks  (5 ‐ 7%) 10% 0% 1 quartile Median 3 quartile Median Spring 2011
  • 8. How Are Investment Valuation Techniques Weighted in the Private Markets? 60% 50% 40% 29% 29% 30% 23% 20% 12% 9% 10% 0% Income Public approach Transaction Asset based company Other (DCF, NPV, approach approach approach IRR) Average 29% 29% 12% 9% 23% Angel 14% 21% 8% 5% 51% VC 15% 40% 16% 5% 23% PEG 34% 27% 16% 12% 9% Brokers 30% 34% 5% 13% 18% Ibanker 34% 34% 15% 11% 6% Appraisers 50% 20% 13% 10% 8%
  • 9. Which Multiples are Used to Determine the Value of a Business? 45% 40% 35% 33% Weight of Use (%) 30% 25% 20% 20% 17% 14% 15% 10% 6% 6% 4% 5% 0% Recast Net EBITDA Cash flow Revenue EBIT EBITDA income Other multiple multiple multiple multiple multiple multiple Average 33% 20% 17% 14% 6% 6% 4% PEG 25% 30% 18% 10% 6% 6% 3% Brokers 34% 15% 24% 12% 5% 4% 7% Ibanker 40% 22% 13% 13% 7% 5% 3% Appraisers 32% 13% 16% 21% 7% 6% 4%
  • 10. Deal and Leverage Multiples 8 7.0 7 6.5 6.0 5.5 Multiple of EBITDA 6 5 4.5 4.0 4 4.8 5.0 4.5 3 4.0 3.5 3.5 2 3.0 3.0 3.0 2.3 2.3 2.5 1 0 $1M $5M $10M $25M $50M $100M EBITDA EBITDA EBITDA EBITDA EBITDA EBITDA Deal multiples 4 4.5 5.5 6 6.5 7 Senior leverage 2.25 2.25 2.5 3 3 3 Total leverage 3.5 3.5 4 4.5 4.75 5 Source: Pepperdine Private Capital Markets Project Fall 2011 Business Owner Survey, Pepperdine University
  • 11. What is the Status of Privately-Held Businesses as of Fall 2011?
  • 12. Businesses: Today vs. 6-Months Ago • Significant increases in prices of labor and materials • Increases in unit sales, net income, opportunities for growth • Receivables periods lengthening • General business conditions declining while significant increase in time worrying about economy
  • 13. What is the State of Financing? • Nearly 91% of business owners report having the enthusiasm to execute growth strategies • Yet just 49% report having the necessary financial resources to successfully execute growth strategies Source: Pepperdine Private Capital Markets Project Fall 2011 Business Owner Survey, Pepperdine University
  • 14. Top Issues Facing Privately–Held Businesses Economic uncertainty (domestic) 2% 2% Access to capital 3% 5% 38% Government regulations and taxes 25% Inflation 26% Economic uncertainty (international) Competition from foreign trade partners Other Source: Pepperdine Private Capital Markets Project Fall 2011 Business Owner Survey, Pepperdine University
  • 15. Business Owners’ Current Sources of Financing (All sizes) 60% 50% 47% Frequency (%) 40% 30% 30% 19% 19% 20% 10% 8% 3% 3% 2% 1% 1% 0.3% 0.3% 0% ‐10%
  • 16. Business Owners’ Current Sources of Financing (>$5 million revenues) 60% 53% 50% 40% 38% 30% 20% 16% 8% 9% 9% 10% 5% 3% 2% 2% 1.4% 0.5% 0%
  • 17. Business Owners’ Estimates of Cost of Equity (by Revenue Size) 25% 23% 19% 20% 19% 17% 17% Cost of Equity (%) 15% 15% 15% 15% 15% 14% 14% 15% 13% 13% 10% 11% 11% 5% 0% Less than $1 million ‐ $5million ‐ $10 million $25 million $50 million $100 ‐ $500 Greater $1 million $5 million $10 million ‐ $25million ‐ $50 ‐ $100 million than $500 million million million Mean Median
  • 18. Small Business Financing Success Rates For Twelve Month Period Ended September 16, 2011 100% 94% 91% 90% 90% 83% 79% 77% 80% 74% 70% 67% 60% 57% 50% 45% 40% 40% 30% 20% 10% 0% Credit Avg. Friends Factor Bank Angel ABL Mezz. Hedge PEG VC card Less than $5M 51% 78% 63% 47% 44% 41% 38% 25% 23% 23% 20% $5M ‐ $25M 64% 90% 85% 58% 72% 25% 61% 25% 8% 44% 30% Greater than $25M 83% 94% 91% 67% 90% 40% 79% 77% 57% 74% 45%
  • 19. Persistence Pays… Average Number of Capital Providers Contacted for Successful Financing Outcome 6.0 5.3 5.0 4.8 4.0 4.0 3.6 3.4 3.2 3.0 2.4 2.4 2.3 2.3 2.0 2.0 1.0 0.0 Source: Pepperdine Private Capital Markets Project Fall 2011 Business Owner Survey, Pepperdine University
  • 20. Business Owners’ Expected Time to Exit (>$5 million revenues) 0.3 25% 0.25 23% 0.2 Percentage (%) About 30% within  16% 0.15 next five years 11% 0.1 5% 6% 6% 0.05 3% 3% 2% 0 < 1 year 1 year 2 years 3 years 4 years 5 years 5‐10 10‐15 15‐20 >20 years years years years
  • 21. Businesses with Revenues >$5M: The Next 12 Months • Significant increases in unit sales along with product/service pricing and prices of labor and materials increases • Increases in net income, opportunities for growth • Receivables periods lengthening • No improvement in general business conditions and further increase in time worrying about economy
  • 22. What’s Happening with Capital Providers?
  • 23. Banks: Today vs. 6-Months Ago • Worsened business conditions and appetite for risk • Demand for loans and underwriting standards flat (despite more due diligence) with slight increase in credit quality of borrowers • Increased focus on collateral as backup means of payment; personal guarantee coverage flat, but starts to burn off around $5 million in loan size • Highly competitive for quality companies; pricing and loan structures back to pre-crash levels
  • 24. Banks: Loan Sizes Underwritten 60% 51% 50% 40% 40% 36% 29% 30% 25% 24% 20% 10% 0% Less than $1M $1M ‐ 5M $6M ‐ $10M $11M ‐ 25M $25M ‐ $50M Greater than $50M Largest concentrations of loan sizes were between $1 million and $25 million
  • 25. Banks: Motivations for Loans Refinancing existing loans or  5% 4% equity Expansion 10% 49% 11% Working capital fluctuations 22% Management buy‐out Finance worsening operating  conditions Other Refinancing accounted for nearly 49% of all lending activity followed by expansion (22%), working capital (11%)
  • 26. Banks: Increased Pressure from Regulators to Avoid Making Risky Loans? 13% 4% Agree 82% Neutral Disagree Banks declined 63% of cash flow based loans over prior six months
  • 27. Banks: Senior Leverage Multiples for Business Services Companies 1st Quartile   Median   3rd Quartile   Spring  Spring  Spring  EBITDA Fall 2011 Fall 2011 Fall 2011 2011 2011 2011 $1M   1.2 1.3 1.2 1.5 1.9 2.0 $5M   2.5 1.4 2.5 2.0 3.0 2.4 $10M   2.5 2.4 2.5 2.5 3.0 3.0 $25M   2.5 2.4 3.0 2.5 3.0 3.0 $50M   2.6 2.5 3.0 3.0 3.0 3.3 $50M   3.1 2.6 3.3 3.0 3.4 3.4 Approximately 1.5X – 2.5X under $25M in EBITDA; 3X and above greater than $25M
  • 28. Banks: Senior Leverage Multiples for Manufacturing Companies 1st Quartile   Median   3rd Quartile   Spring  Spring  Spring  EBITDA Fall 2011 Fall 2011 Fall 2011 2011 2011 2011 $1M   1.3 1.5 1.3 1.8 2.0 2.0 $5M   2.1 1.5 2.5 1.8 3.0 2.1 $10M   2.4 2.3 2.5 2.5 3.0 2.8 $25M   2.6 2.4 3.0 2.5 3.0 3.0 $50M   2.5 2.5 3.0 3.0 3.0 3.3 $100M   2.3 2.7 3.0 3.3 3.2 3.5 Approximately 1.8X – 2.5X under $25M in EBITDA; 2.5X and above greater than $25M
  • 29. Banks: All in Rates on Cash Flow Loans (%) 1st Quartile  Median  3rd Quartile  Spring  Spring  Spring  EBITDA Fall 2011 Fall 2011 Fall 2011 2011 2011 2011 $1 million  5.4 5.5 6.5 7.0 7.1 7.0 $5 million  5.0 5.8 5.5 6.0 6.0 6.0 $10 million  4.5 5.0 5.5 5.5 7.0 5.5 $25 million  3.8 4.8 5.5 5.5 7.2 6.5 $50 million  3.5 3.8 5.0 4.0 7.4 6.5 Rates correspond to loan terms of 60 months (median) Slight increase in all-in-rates on cash flow loans over the last 6 months, except for large companies
  • 30. Banks: Financial Evaluation Metrics (Medians) Average  Importance  Approval Limits  Borrower   Score (0‐4)   Spring  Fall      Spring  Fall  Spring  Fall  2011 2011 2011 2011 2011 2011 Current ratio 1.4 1.4 1.3 1.1 1.7 1.6 Total debt service coverage  1.3 1.3 1.3 1.2 3.7 3.5 ratio Total debt to cash flow 2.5 2.8 2.8 4.0 3.2 3.0 Debt to net worth  2.0 2.0 2.4 3.0 2.5 2.2 Approval thresholds in Fall 2011 are lower than in Spring 2011 but average borrower characteristics are relatively constant
  • 31. Banks: The Next 12 Months • Sharp increase in demand for loans, lending capacity of banks and SBA lending • Underwriting standards and credit quality of borrowers relatively flat • Further increases (slight) in senior/total leverage multiples • Relatively flat business conditions • Increasing due diligence efforts and further pricing compression
  • 33. ABLs: Today vs. 6-Months Ago • Increased demand for loans • Slight increase in standard advance rates on collateral • Compressed loan fees and spreads • Increase in loans outstanding • Slight decline in business conditions
  • 34. ABLs: Loan Sizes Underwritten 60% 50% 48% 40% 30% 28% 28% 24% 20% 16% 16% 16% 10% 8% 0% Less than $1M ‐ 5M $5M ‐ $10M ‐ $25M ‐ $50M ‐ $100M ‐ Greater $1M $10M 25M $50M $100M $500M than $500M Largest concentrations of loan sizes were between $1 and $5 million (48%)
  • 35. ABLs: Motivations Refinancing 5% 13% Finance worsening operations  13% conditions 55% Fluctuating working capital 17% Expansion Other Refinancing accounted for nearly 55% of all lending activity followed by worsening operations conditions (13%) and working capital (13%)
  • 36. ABLs: Advance Rates Typical Loan  (Median %) Upper Limit (Median %)  Spring  Fall 2011 Spring 2011 Fall 2011 2011 Marketable securities 80 90 90 90 Accounts Receivable 80 85 85 85 Inventory ‐ Low quality 25 25 40 30 Inventory ‐ Intermediate  40 45 50 50 quality Inventory ‐ High quality 55 60 60 60 Equipment 60 75 80 75 Real Estate 60 65 70 70 Land 50 40 50 42 On average, advance rates are slightly higher than 6 months ago
  • 37. ABLs: Collateral Valuation Standards 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Purchase price 10% 6% Depreciated Value (Book) Face value 35% Fair Market Value 87% Forced Liquidation 33% 63% Orderly Liquidation 44% Other Equipment Real estate Accounts Receivable Inventory
  • 38. ABLs: All in Rates (%) Type and Size  1st Quartile  Median  3rd Quartile  Spring  Fall  Spring  Fall  Spring  Fall  2011 2011 2011 2011 2011 2011 WORKING CAPITAL $5M 5.0 6.8 7.0 9.3 11.0 12.0 $25M 3.0 3.8 3.4 4.9 4.4 10.5 $50M 3.0 2.8 3.3 3.0 4.0 3.3 $100M 2.6 2.5 3.0 2.8 3.4 3.1 EQUIPMENT $5M 5.3 5.5 7.3 6.5 8.9 6.5 $25M 3.9 3.4 5.8 3.6 7.1 3.9 $50M 3.5 2.6 4.0 2.8 5.6 3.1 $100M 3.4 2.5 4.0 2.5 4.6 2.5 All-in-rates are lower than 6 months ago except small size lending with working capital as a collateral
  • 39. ABLs: Financial Evaluation Metrics (Medians) Average  Approval  Importance  Borrower  Limits  Score (0‐4)  Spring  Fall  Spring  Fall  Spring  Fall  2011 2011 2011 2011 2011 2011 Current ratio 1.0 1.7 1.0 1.2 1.1 0.9 Total debt service  1.2 1.1 1.0 1.0 2.6 2.4 coverage ratio  Total debt to cash flow 3.5 3.0 3.8 4.0 2.4 2.3 Debt to net worth  2.1 2.8 2.5 2.7 2.1 1.7 Revenue growth rate 1.1% 5.0% 1.0% 5.0% 1.5 1.8
  • 40. ABLs: The Next 12 Months • Sharp increase in demand for loans and loans outstanding • Underwriting standards slightly more stringent but credit quality of borrowers will continue to improve • See business conditions generally flat • Relatively flat pricing
  • 41. What’s Happening with Mezzanine Capital?
  • 42. Mezzanine: Today vs. 6-Months Ago • Demand for mezzanine financing up • Increased credit quality of borrowers • Warrant coverage down, deal and leverage multiples up, expected returns down with more competition • Time to exit investments slightly longer • Underwriting standards relatively flat • Significant decrease in general business conditions
  • 43. Mezzanine: Loan Sizes Underwritten 70% 60% 58% 50% 39% 37% 40% 30% 20% 18% 10% 10% 6% 5% 0% Less than $1M ‐ 5M $5M ‐$10M$10M ‐25M $25M ‐ $50M ‐ $100M ‐ $1M $50M $100M $500M Largest concentrations of loan sizes were between $5 and $10 million (58%)
  • 44. Mezzanine: Loan Motivations Acquisition loan 5% 2% Management buyout 15% 29% Refinancing 15% 28% Financing growth Working capital fluctuations Finance worsening operations  conditions Acquisition loan investments accounted for 29% of activity, followed by MBO (28%), refinancing (15%) and growth (15%)
  • 45. Mezzanine: To Make One Investment… 70 60 60 50 40 40 30 20 15 10 10 6 8 2 2 0 Plans Reviewed Meetings Proposal Letters LOI Median Average
  • 46. Mezzanine: Interest Rates (%) Sponsor Transactions 1st Quartile (%) Median (%) 3rd Quartile (%) Spring  Spring  Spring  EBITDA Size Fall 2011 Fall 2011 Fall 2011 2011 2011 2011 $1M  12 12 13 12 14 13 $5M  12 12 13 12 13 13 $10M  12 11 13 12 13 12 $25M  12 10 12 11 12 12 $50M  10 11 12 $100M  7 11 12 Mezzanine interest rates for sponsor transactions are lower than 6 months ago
  • 47. Mezzanine: PIK (%) Sponsor Transactions 1st Quartile (%) Median (%) 3rd Quartile (%) Spring  Spring  Spring  EBITDA Size Fall 2011 Fall 2011 Fall 2011 2011 2011 2011 $1M  3 1 4 1 4 2 $5M  2 1 3 3 4 3 $25M  3 3 3 4 3 4 $50M  4 4 4
  • 48. Mezzanine: Total Expected Returns (%) Sponsor Transactions 1st Quartile (%) Median (%) 3rd Quartile (%) Spring  Spring  Spring  EBITDA Size Fall 2011 Fall 2011 Fall 2011 2011 2011 2011 $1M  18 16 20 20 22 21 $5M  18 19 20 20 22 26 $10M  17 15 19 18 20 20 $25M  18 12 19 16 19 20 $50M  13 14 15 $100M  7 13 16 Mezzanine total returns decreased for $10 million and $25 million loans in the last 6 months
  • 49. Mezzanine: Interest Rates (%) Non-Sponsor Transactions 1st Quartile (%) Median (%) 3rd Quartile (%) Spring  Spring  Spring  Fall 2011 Fall 2011 Fall 2011 2011 2011 2011 $1M  13 10 14 12 14 14 $5M  12 12 14 12 14 14 $10M  12 12 12 12 13 14 $25M  12 10 12 12 13 13 Mezzanine interest rates for non-sponsor transactions are slightly lower than 6 months ago
  • 50. Mezzanine: PIK (%) Non-Sponsor Transactions 1st Quartile (%) Median  (%) 3rd Quartile (%) Spring  Spring  Spring  Fall 2011 Fall 2011 Fall 2011 2011 2011 2011 $1M  2 2 2 2 2 2 $5M  1 2 2 2 2 2 $25M  3 2 3 3 3 3 $50M  2 3 3 Relatively constant percentages
  • 51. Mezzanine: Total Expected Returns (%) Non-Sponsor Transactions 1st Quartile (%) Median (%) 3rd Quartile (%) Spring  Spring  Spring  Fall 2011 Fall 2011 Fall 2011 2011 2011 2011 $1M  23 17 24 19 25 20 $5M  22 20 22 19 24 25 $10M  20 16 20 18 21 25 $25M  18 15 18 17 19 21 Mezzanine total returns decreased for almost all loan sizes in the last 6 months
  • 52. Mezzanine: Total Leverage Ratios 1st Quartile (%) Median (%) 3rd Quartile (%) Spring Spring Spring Fall Fall 2011 Fall 2011 2011 2011 2011 2011 $1M 2.9 3.0 3.5 3.5 4.1 3.5 $5M 3.5 3.0 3.5 3.5 4.0 4.0 $10M 3.5 3.5 4.0 4.0 4.0 4.5 $25M 4.4 4.0 4.8 4.5 5.0 5.0 $50M 4.0 4.8 5.0 $100M 5.0 5.0 5.5 Represents additional 1 – 2 turns of EBITDA (after senior), increasing with size. Relatively constant when compared to Spring 2011.
  • 53. Mezzanine: Time to Exit (Months) 1st Quartile Median 3rd Quartile Spring Fall Spring Fall Spring Fall 2011 2011 2011 2011 2011 2011 $1M 36 60 48 60 63 60 $5M 48 60 54 60 60 60 $10M 48 60 60 66 60 72 $25M 33 60 36 60 42 72 $50M 60 72 78 $100M 72 78 84 Looking to exit in 5-7 years Exit times are longer than 6 months ago
  • 54. Mezzanine: Financial Evaluation Metrics (Medians) Average      Approval   Importance  Borrower  Limits   Score (0‐4)  Spring  Fall     Spring  Fall     Spring  Fall     2011 2011 2011 2011 2011 2011 Senior debt service  1.6 1.5 1.3 1.2 3.3 2.4 coverage ratio  Total debt service  1.3 1.4 1.2 1.2 2.7 3.3 coverage ratio  Senior debt to cash flow  2.5 2.5 3.0 3.0 3.4 2.9 Total debt to cash flow  3.5 4.0 4.0 4.0 3.4 3.6
  • 55. Mezzanine Investments: Transactions in Next 12 Months 0 to 2 11% 7% 3  to 5 13% 39% 6 to 10 32% 11 to 15 more than 15 Largest concentration of responses indicates plan for 3 – 5 transactions in next 12 months (39%); 32% are planning between 6 and 10
  • 56. Mezzanine Investments: Segments Targeted in Next 12 Months Business Services 2% 3% Manufacturing 8% 22% 8% Health Care 10% Retail and Consumer Services 21% 12% Wholesale & Distribution 14% Information Technology Basic Materials & Energy Financial Services Other Business services (22%), manufacturing (21%), and healthcare (14%) look to be areas targeted for investment
  • 57. Mezzanine: A View to the Next 12 Months • Increasing demand for mezzanine capital, but flat leverage multiples • Slight increase in underwriting standards • Relatively flat loan fees, PIK, and warrant coverage • Significant decrease in general business conditions • Increasing size of mezzanine industry with additional competition from business development companies (BDCs) and SBIC funds
  • 58. What’s Happening with Private Equity?
  • 59. Private Equity: Today versus 6 Months Ago • Increased demand for private equity and increases in quality of companies • Increased deal multiples, exit times longer • Increased amount of non-control investments • Decrease in expected returns on new investments and lower appetite for risk • Worsened general business conditions
  • 60. Private Equity: Investment Activity in Last Six Months 4% 4% 0 7% 26% 1 11% 2 17% 3 31% 4 5 more than 5 Nearly 74% of respondents reported making a deal in the last 6 months; approximately 26% reported no transactions
  • 61. Private Equity: Investment Checks Written 40% 35% 35% 33% 33% 30% 30% 25% 20% 18% 16% 15% 10% 8% 5% 3% 0% Less than $1‐5 $5‐$10 $10‐25 $25‐$50 $50‐$100 $100‐$500 Greater $1 million million million million million million million than $500 million The largest concentration of checks written was in the $10 - $25 million range (35%) followed by $25 - $50 million (33%) and $5 - $10 million (33%)
  • 62. Private Equity: To Make One Investment… 160 142 140 120 100 100 80 60 40 22 20 15 5 9 2 2 0 Plans Reviewed Meetings Proposal Letters LOI Median Average
  • 63. Private Equity Balance of Capital with Businesses Worthy of Financing: Surplus or Shortage? 1.2 0.7 0.7 0.7 0.5 0.6 Relative  0.3 Score (‐2 to 2) 0.2 Shortage 0.1 ‐0.3 ‐0.6 ‐0.8 ‐0.9 ‐1.3 $1M $5M $10M $15M $25M $50M $100M > $100M EBITDA EBITDA EBITDA EBITDA EBITDA EBITDA EBITDA EBITDA Score ‐0.9 ‐0.6 0.1 0.3 0.5 0.6 0.7 0.7
  • 64. Private Equity: Difficulty Securing Senior Debt? 3.0 2.5 2.3 2.0 1.8 1.7 1.7 Score (‐3 to 3) 1.5 1.3 1.0 0.5 0.4 0.0 ‐0.5 ‐0.5 ‐1.0 $1M $5M $10M $15M $25M $50M $100M+ EBITDA EBITDA EBITDA EBITDA EBITDA EBITDA EBITDA Score ‐0.5 0.4 1.3 1.8 1.7 1.7 2.3
  • 65. Private Equity: Deal Multiples (of EBITDA) EBITDA   1st Quartile   Median   3rd Quartile   Spring  Spring  Spring  Fall 2011 Fall 2011 Fall 2011 2011 2011 2011 $1M   3.9 3.0 4.0 4.0 5.3 5.5 $5M   4.5 3.5 5.0 4.5 5.7 6.0 $10M   5.0 4.5 6.0 5.5 7.0 7.0 $25M   5.5 5.0 6.0 6.0 7.8 7.5 $50M   7.5 5.0 7.5 6.5 8.0 8.5 Median deal multiples starting to exhibit weakness
  • 66. Private Equity: Equity Contributions (%) EBITDA   1st Quartile (%) Median (%) 3rd Quartile (%) Spring  Spring  Spring  Fall 2011 Fall 2011 Fall 2011 2011 2011 2011 $1M 39 45 60 60 83 95 $5M 40 45 60 55 70 85 $10M 50 38 58 50 62 55 $25M 25 35 48 45 60 53 $50M 21 25 33 35 40 35 $100M 10 35 20 35 23 55 Median equity contributions reported range from a high of 60% for smaller transactions to 35% for larger companies
  • 67. Private Equity: Expected Returns (%) EBITDA   1st Quartile (%) Median (%) 3rd Quartile (%) Spring  Spring  Spring  Fall 2011 Fall 2011 Fall 2011 2011 2011 2011 $1M 25 25 30 30 35 38 $5M 25 23 30 25 30 35 $10M 25 23 30 25 31 30 $25M 25 23 28 25 30 30 $50M 22 23 25 25 30 30 $100M 23 25 27 $500M 21 23 27 Expected gross annual returns on new investment range from a median of 25% for most large transactions to 30% for smaller ones Expected returns are significantly lower than 6 months ago
  • 68. Private Equity: Exit Times (Months) EBITDA   1st Quartile Median  3rd Quartile Spring  Spring  Spring  Fall 2011 Fall 2011 Fall 2011 2011 2011 2011 $1M  48 48 60 60 60 60 $5M  48 48 60 60 60 60 $10M  36 46 48 60 48 60 $25M  37 40 48 48 60 51 $50M  48 30 48 48 60 48 $100M  48 48 48 48 48 60 $500M  48 48 60 Expected exit times range from 48 months for larger transactions to 60 months for smaller ones
  • 69. Private Equity Investing: Number of Transactions in Next 12 Months 0 2% 5% 1 6% 8% 9% 2 9% 30% 3 30% 4 5 6 more than 6 60% are looking to make 2 – 3 investments in the next year
  • 70. Private Equity Investing: Segments Targeted in Next 12 Months Manufacturing 6% Business Services 13% 19% 6% Health Care 7% 16% Retail & Consumer Services 9% Basic Materials & Energy 12% 12% Wholesale & Distribution Financial Services Information Technology Other Manufacturing (19%), business services (16%), healthcare (12%), and retail & consumer services (12%) appear to be the targets of 59% of investments
  • 71. Private Equity: A 12-Month View • Increasing demand for private equity and quality of companies seeking investment • Increasing amount of non-control investments • Deal multiples increasing further • Generally flat to slightly lower expected returns on new investments • Worsening general business conditions and lower appetite for risk
  • 73. Investment Bankers: Today vs. 6-Months Ago • Deal flow up slightly • Relatively flat leverage and deal multiples • Extended time / increased difficulty to sell business • Increased presence of strategic buyers • Increased margin pressure on companies • Worsened business conditions
  • 74. Investment Banks: Business Sales Transactions in Last 6 Months 0 1 6% 6%3% 9% 25% 2 7% 3 20% 24% 4 5 6 more than 6 75% report making at least one deal in last 6 months; 51% made between 1 – 3 while 25% didn’t make any
  • 75. Investment Banks: Time to Transact Businesses in Last 6 Months 4% 2 ‐ 4 months 9% 7% 22% 4 ‐ 6 months 16% 6 ‐ 8 months 13% 8 ‐ 10 months 29% 10 ‐ 12 months 12 ‐ 18 months more than 18 months The largest concentration of transactions closed in 6-8 months (29%); another 22% closed in 4-6 months
  • 76. Investment Bankers: Percentage 33.5% of Deals with … 33.0% 32.8% 32.5% 32.0% 31.9% Frequency (%) 31.5% 31.1% 31.0% 30.7% 30.5% 30.0% 29.5% 29.0% Seller Financing / Contingent Adjusted amount Lowered multiple Seller Note earnout of equity  sold of EBITDA
  • 77. Investment Banks: Are Strategics Outbidding Financial Buyers? No 3% 2% 13% 19% Yes, 0‐10% more 13% 23% Yes, 11‐20% more Yes, 21‐30% more 28% Yes, 31‐40% more Yes, 41‐50% more Yes, >50% more Roughly 19% report that strategic buyers didn’t pay premiums relative to financials’ offers; 23% report premiums less than 10% and another 28% report premiums between 11-20%
  • 78. Investment Banks: 43% of Engagements Expired Without Transaction! Why? Valuation gap in pricing Economic uncertainty 8% 6% 6% 2% 29% Unreasonable seller or buyer demand 14% Lack of capital to finance 18% No market for business 17% Other Insufficient cash flow Seller misrepresentations 37% report valuation gap of less than 20%; 39% report 21 – 30% valuation gap
  • 79. Investment Bankers: Difficulty 2.5 Securing Senior Debt? 1.9 2.0 2.0 1.6 1.5 1.3 Score (‐3 to 3) 1.1 1.0 0.4 0.5 0.0 ‐0.5 ‐1.0 ‐0.9 ‐1.5 $1M $5M $10M $15M $25M $50M $100M+ EBITDA EBITDA EBITDA EBITDA EBITDA EBITDA EBITDA PEGs ‐0.5 0.4 1.3 1.8 1.7 1.7 2.3 I‐Bankers ‐0.9 0.4 1.1 1.3 1.6 1.9 2.0
  • 80. Investment Bankers: Balance of Capital with Businesses Worthy of Financing: 1.5 Surplus or Shortage? 1.0 0.8 0.9 0.7 Score (‐2 to 2) 0.5 0.3 0.1 0.0 ‐0.1 ‐0.5 ‐0.6 ‐1.0 ‐1.0 ‐1.5 $1M $5M $10M $15M $25M $50M $100M > $100M EBITDA EBITDA EBITDA EBITDA EBITDA EBITDA EBITDA EBITDA PEGs ‐0.9 ‐0.6 0.1 0.3 0.5 0.6 0.7 0.7 I‐Bankers ‐1.0 ‐0.6 ‐0.1 0.1 0.3 0.7 0.8 0.9
  • 81. Investment Banks: Next 12-Months Transactions Forecast 2% 0 7% 7% 13% 1 12% 2 16% 23% 3 20% 4 5 6 more than 6 Almost half (48%) report an expectation to transact between 3 and 5 businesses during the next 12 months
  • 82. Investment Banks: The Next 12 Months • See deal flow up sharply • Relatively flat leverage and deal multiples • Extended time / slightly increased difficulty to sell business • Increased presence of strategic buyers • Increased margin pressure on companies • Worsening business conditions
  • 83. What’s Happening with Limited Partners?
  • 84. What about the Limited Partners (LPs)? • Compared to six months ago... – Allocations to VC, Mezz, Hedge, Secondaries down slightly – Allocation to PE up slightly – Direct investments are up – Business conditions down but expected returns on new investment up
  • 85. Limited Partners: Strategy with Best Risk and Return Trade-off? 25% 20% 20% 19% 15% 13% 11% 10% 7% 7% 7% 6% 6% 5% 4% 0%
  • 86. Industry Segments with Best Risk and Return Tradeoffs 0.6 48% Frequency of Response (%) 0.5 0.4 36% 34% 30% 0.3 24% 0.2 12% 10% 10% 0.1 8% 0 86
  • 87. Limited Partners’ Return Expectations on New Investments (%) 25.0 20 20 20 20.0 18 18 Gross expected returns (%) 15 15 15 15 15.0 13 10.0 5.0 0.0 PE ‐ PE ‐ PE ‐ Second Real Fund of VC Directs Mezz Hedge Buyout Grow Distr. . Estate Funds Median 20.0 20.0 20.0 18.0 18.0 15.0 15.0 15.0 15.0 12.5 Mean 21.0 20.4 19.3 19.4 17.4 17.4 13.1 13.1 14.3 12.5
  • 88. Importance of Factors When Raising Funds 5 4.5 4.4 4.0 4 Importance Factor (1‐5) 3.5 3.5 3.3 3.2 3 2 1 0 General Specific Hist. Perf. all Returned Residual Gut feel / Specific partner strategy Funds capital from value of Instinct location most recent most recent fund (DPI) fund (RVPI)
  • 89. LPs: The Next 12 Months • Increasing allocations to alternative assets • See best domestic opportunities in California, Texas, New England states • Allocations to various strategies relatively flat, but direct investments up • Business conditions and expected returns up slightly
  • 90. Conclusions • Deteriorated business conditions across all segments surveyed; no significant improvements expected in next 12 months • Starting to see early signs of leverage / valuation stagnation (and decline), accompanied with higher pricing, particularly for smaller businesses • Extremely competitive conditions for quality large companies • Capital intensive businesses appear to be eligible for more favorable loan pricing (ABL) and are likely to continue with extended economic weakness
  • 91. Conclusions (Cont’d) • Expected returns on new investments declining with longer exit times; more competition • Opportunities appear to exist for investments in smaller businesses (< $10M EBITDA); debt more available than it was six months ago in $5M EBITDA segment • See increased opportunities for working capital funding with receivables extending, inventories building, and margins compressing • Expected continued demand for all capital types • Invest cautiously
  • 92. A True Win-Win… Top Policy Actions for Job Growth in 2012 According to 10,644 Small Business Owners Increased access to capital 3.8% 12.0% 7.9% 34.8% Tax incentives Regulatory reform 18.3% 23.2% Increased competitiveness with foreign trade partners Education reform Other Source: Pepperdine Private Capital Markets Project Fall 2011 Business Owner Survey, Pepperdine University
  • 93. Thank You! John K. Paglia, Ph.D., CFA, CPA Associate Professor of Finance Senior Researcher, Pepperdine Private Capital Markets Project bschool.pepperdine.edu/privatecapital john.paglia@pepperdine.edu