Fall 2010 SRR Journal

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SRR Fall 2010 Valuation Journal

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Fall 2010 SRR Journal

  1. 1. FALL 2010PUBLIC & LARGE PRIVATE COMPANY EDITIONUnlocking the Complexity ofPerformance Units with TotalShareholder Return Requirements■ 34International Cost of Equity: The Science Behind the Art ■ 20A Proposed Accounting “Game Changer” with Respect to Leases ■ 42Separation Anxiety: Fair Value Implications of Issuing Debt and PreferredStock with Conversion Features and Other Options 47 ■
  2. 2. “…Companies are now introduced to unanticipated “tax paying” issues…” – Q&A, Page 133 Dear Clients and Friends: At SRR we work closely with public and large private companies to address a wide range of complex financial issues. Please take a look at the Table of Contents on page 2 to browse the full collection of recent articles from our firm. I have indentified a few pieces below that may be of particular interest to you. If you have any questions or comments, please contact me. Sincerely, Mr. Jay B. Wachowicz, CFA jwachowicz@srr.com ■ 248.432.1288 FEATURED ARTICLES34 Unlocking the Complexity of 42 A Proposed Accounting “Game Changer” Performance Units with Total with Respect to Leases Shareholder Return Requirements This article discusses the joint effort between U.S. Commonly employed financial instruments such standard setters and their respective international as stock options and restricted stock awards have counterparts to dramatically alter the accounting advantages and disadvantages as contemplated by requirements associated with lease accounting. equity investors and employees. One of the more recent Given the magnitude of real property from an expense developments in this regard relates to the introduction structure standpoint, this article highlights various of performance units with total shareholder return issues associated with this asset class specifically. requirements. This article addresses the methodologies utilized to value performance units, as well as the 47 Separation Anxiety: Fair Value Implications associated value drivers. of Issuing Debt and Preferred Stock with Conversion Features and Other Options20 International Cost of Equity: Many early-stage or credit-starved firms often turn The Science Behind the Art to convertible bonds or similar instruments to entice As companies continue to expand operations to investors while limiting the near-term cash flow burden locations throughout the world (including certain of interest payments. While convertibles can provide emerging markets), the measurement of country risk the issuer much needed capital and operational has become a key element of a valuation. This article flexibility, they can also create accounting and valuation discusses the various methodologies used to estimate challenges at issuance, as well as in subsequent an appropriate cost of equity for foreign countries. reporting periods.
  3. 3. Unparalleled expertise Deep industry knowledge Great to work withINVESTMENT VALUATION & DISPUTE ADVISORY BANKING FINANCIAL OPINIONS & FORENSIC SERVICES www.srr.com SRR is a trade name for Stout Risius Ross, Inc. and Stout Risius Ross Advisors, LLC, a FINRA registered broker-dealer and SIPC member firm.
  4. 4. C ON TEN TS 45 Funded vs. Unfunded Secondary Transactions 4 30 Timothy F. Cummins and Dana J. O’Brien – Cornerstone Equity Investors, LLC 7 4 The Role of the Board in 30 Ownership Transition – Using Mergers & Acquisitions Tax Advantaged ESOPs in a Jeffrey S. Phillips and Challenging Credit Environment Michael J. Levitin – Wilmer Hale Jeffrey S. Buettner 8 M&A and Financing 47 Separation Anxiety: Fair Value Market Update 34 Implications of Issuing Debt and Terrel G. Bressler Preferred Stock with Conversion and David E. West Features and Other Options 12 Guest Article: The Benefits of Ryan A. Gandre Mezzanine Financing for Middle Market Companies 52 Guest Article: Common Mistakes 34 Unlocking the Complexity Patrick Rond and Nicholas Observed in Insurance Related of Performance Units Stone – Key Principal Transaction Due Diligence with Total Shareholder Partners Corp. Christopher J. Veber – Return Requirements Equity Risk Partners Jay B. Wachowicz and Denis F. Cash 16 Dividend Recaps: Trends and the Importance 6 36 55 55 Impact of Recent Market Trends of Solvency Opinions on Section 1111(b)(2) Elections 38 Valuation Formulas in Involving Real Property Aziz El-Tahch Shareholders’ Agreements Jeffrey M. Risius, Jeffrey G. Christopher P. Casey and Pelegrin, and Jesse A. Ultz 20 International Cost of Equity: Aaron M. Stumpf The Science Behind the Art Jay B. Wachowicz and 42 A Proposed Accounting Brian A. Hock 59 “Game Changer” with Respect 26 Medical Device and to Leases Equipment Industry Overview Jason J. Krentler and Robert J. Andrews, Jr., Denis F. Cash Robert A. Hauptman, and Craig T. Hickey 59 Warning! The Service Believes S Corporations are Undervalued Daniel R. Van Vleet ©2010
  5. 5. 63 Alternative Techniques in 101 Court Once Again Addresses Valuing Real Estate Portfolios Insufficient Support for Damages 83 Jeffrey G. Pelegrin, Award in a Patent Case Christopher P. Casey, and John R. Bone, Erich W. Kirr, Joseph L. Torzewski and Allen Burt68 In Re Sunbelt Beverage Corp. Shareholder Litigation: 05 83 Auditing Self-Reporting A Delaware Fair Value Agreements Case Analysis John R. Bone and Timothy F. Cummins Jason T. Wright71 When the Chain Breaks… Assessing Damages in Cases 86 Building a Best in Class 105 Applying the Structured Involving Disruptions to Complex Corporate Compliance Program Settlement Concept to Divorces Supply Chains Glenn C. Sheets James M. Godbout, Glenn C. Sheets and Daniel T. Carroll – AVITAS Jacob M. Reed Financial, and John M. 90 McCulloch – AVITAS Financial74 Guest Article: Fraud Risk Management in the Banking Industry 109 Guest Article: Reviewing Estate Andrea J. Steinkamp – Guest Plans in Connection with Divorce Contributor and Tina B. Solis – Joan K. Crain – BNY Mellon Ungaretti & Harris, LLP 90 Managing Occupational Wealth Management Fraud Risks 113 The Taxing Side of Divorce Michael N. Kahaian and Mary V. Ade 79 Jason T. Wright 116 Guest Article: Family Office 94 Proactive Planning for Challenges and Solutions E-Discovery Challenges for Sustainability Scott T. Wrobel and Michael P. Benetta Park Jenson – Hindelang – Honigman Miller Bessemer Trust Company, N.A.79 Making E-Discovery Work for Schwartz and Cohn LLP You in International Arbitration 121 Reasonable Compensation: A David N. Paris and 99 “Fundamentally Unsupported by Key Issue in Marital Dissolution Tomoko Tatara the Facts”: Eighth Circuit Affirms Justin L. Cherfoli and Dismissal of Financial Expert Christopher P. Casey Neil Steinkamp 125 In Case You Were Wondering… Mary V. Ade 128 A Preliminary Look at SRR’s Restricted Stock StudyWe welcome any comments, suggestions, or questions. Please refer to the end of each article for the individual Aaron M. Stumpf andauthor contact information. Robert L. MartinezThe SRR Journal is intended for general information purposes only and is not intended to provide, and should notbe used in lieu of, financial, accounting, legal or other professional advice. The publisher assumes no liability forreaders’ use of the information herein and readers are encouraged to seek professional assistance with regard tospecific matters. All opinions expressed in these articles are those of the authors and do not necessarily reflect theviews of Stout Risius Ross, Inc. or Stout Risius Ross Advisors, LLC.The SRR Journal is also available online at www.srr.com.SRR is a trade name for Stout Risius Ross, Inc. and Stout Risius Ross Advisors, LLC,a FINRA registered broker-dealer and SIPC member firm.
  6. 6. The Role of the Board in Mergers & Acquisitions Jeffrey S. Phillips – jphillips@srr.com Michael J. Levitin – WilmerHale – michael.levitin@wilmerhale.comThis article offers a brief overview of the role of the Board of ■ The interests of directors and senior managers in someDirectors in mergers and acquisitions. By better understanding transactions may not be entirely aligned.the board’s role, directors (and officers) can increase stockholder ■ In the current environment, everyone is concerned aboutvalue, reduce conflict within the organization, and mitigate litigation.litigation risk. Returning to the two questions above:Overview ■ ■ ■ ■ Directors and officers play fundamentally different roles withinThe question, what is the board’s role in M&A?, raises two separate a corporation. Under Delaware law, “[t]he business and affairsbut related questions: of every corporation . . . shall be managed by or under the■ How does the role of the board differ from the role direction of a board of directors . . ..” As a practical matter, of management? most companies are managed under the direction of the board: the board oversees management, and management■ How does the board’s role in M&A differ from the board’s role is responsible for the company’s day-to-day activities. At the in the company’s other business activities? highest level, the board is responsible for approving or setting the strategy for a business, and management is responsibleThese questions arise for many reasons, including the following: for executing that strategy. Expressing this allocation of■ Directors are sensitive to the prerogatives of management but responsibilities colloquially, only the board can govern, and focused on fulfilling their own responsibilities. only management can manage.■ Many directors have experience with M&A, either as officers ■ The role of the board in M&A varies with the significance of of their own companies, or directors of other companies that a transaction. Consistent with the role of the board generally, have engaged in transactions, or as professional advisors – a board should be relatively uninvolved with insignificant bankers, accountants, consultants, or attorneys – with transactions and increasingly involved as transactions M&A expertise. become more significant. The board should be highly involved in major, strategic acquisitions and in sales of the company or■ Transactions that rise to the board-level are significant events, all, or substantially all, of its assets. but at many companies are sufficiently infrequent that directors and management may not have thoroughly vetted procedures or an adequate understanding of their respective roles.©2010 4 ©2010
  7. 7. The Board’s Role in M&A Generally ■ ■ ■ ■ Cultural clashes ■ Failures in integrating the acquired businessIt’s helpful to think of M&A as one of the ways that a company canexecute its business plan and deliver value to its shareholders. Directors should review these issues with management. On theseDirectors play many roles within the organization, but among their issues, in particular, directors have a perspective that is informedprincipal functions are: by a range of experience, sympathetic to the company’s goals, and separated from the pressures of the deal, and directors have the■ Setting strategy standing to challenge over-optimistic assumptions and emphasize■ Monitoring corporate performance and management the importance of integration.■ Overseeing risk management Board Responsibilities in Connection■ Counseling the CEO on the most difficult challenges facing with a Sale of the Company ■ ■ ■ the business On the sell-side, the situation is a bit different because a sale■ Championing good governance transaction, particularly a sale of the company as a whole, can■ Offering constructive criticism be the best opportunity for stockholders to achieve a premium for their investment. Here, too, the board’s principal role is strategy,All of these roles are relevant to M&A. In practice, directors play the governance, and oversight, with added considerations that arise insame role in transactions that they do in all other aspects of the connection with a sale. One of these considerations pervades thecompany’s business – oversight and governance – with some roles sales process; two arise at the commencement of any process.and responsibilities that are specific to the M&A context. ■ In some transactions, generally known by the name of theOn the buy-side, the board’s higher level perspective provides a leading Delaware case, Revlon, Inc. v. MacAndrews & Forbesspecial vantage point from which the board can help maximize Holdings, Inc., the board is obligated to secure the best pricestockholder value: reasonably available for stockholders. While the precise■ The board is responsible for approving a company’s strategic contours of the Revlon doctrine are beyond the scope of this plan, and the board should evaluate proposed acquisitions in article, in general, a sale of the company for cash triggers the context of that plan. Revlon duties. For this reason, boards should begin with the end in mind: they should assume that their decisions may■ The board has a strategic view of the company’s resources – need to withstand scrutiny under Revlon, and they should act both financial and managerial – and the board should throughout the process to maximize stockholder value. assess whether a proposed transaction is the best use of those resources. ■ Before initiating a sales process, the board should assess whether this is an opportune time to sell the company. Under■ The board selects the CEO and can influence the selection of Delaware law, the decision on whether to sell or not sell the senior management. If the board wants the company to grow company is a decision for the board. Even if the company through acquisitions, the board needs to take appropriate steps receives an offer at a premium to the company’s current to ensure that the management team includes individuals with market value, the board – with the assistance of its advisors – the skills required to execute transactions and integrate the can assess whether stockholder value would be maximized businesses that are acquired. by selling at that time, in response to that offer, or selling atAll of these are strategic, board-level issues that the board should a different point in the business cycle or at a differentevaluate – and that only the board can evaluate – before the point in the company’s development, taking into accountcompany embarks on an acquisition. the company’s long-term strategic plan and whether the company’s stockholders are better served by the companyConsistent with their responsibility for strategy, governance, and remaining independent.oversight, directors should bring a strategic perspective to their ■ With the assistance of its professional advisors, the boardreview of proposed acquisitions that rise to the board-level. should adopt a process that maximizes stockholder value.Directors should carefully probe the financial underpinnings of Under Delaware law, there is no single blueprint for the saleproposed acquisitions, which may be premised on unrealistic of a company, and the answer will vary depending on theassumptions about growth and cost-savings. Directors should be company’s situation. But, in general, a thorough market checkaware of the principal reasons why acquisitions do not achieve before signing an agreement, and the ability to accept superiortheir anticipated results, including: offers that emerge after signing, help establish that the board has endeavored to maximize value for stockholders. A good■ Overpayment for the target process also helps mitigate litigation risk.■ An incomplete understanding of the business being acquired (including its liabilities and intellectual property)©2010 5 ©2010
  8. 8. While the sales process is unfolding, the board should oversee the ■ Management favors one transaction because it involves greaterprocess, guiding management and the company’s advisors with compensation for management than competing deals.a view to maximizing stockholder value and fulfilling the board’s ■ A controlling stockholder will receive somewhat moreRevlon duties. consideration per share than minority stockholders: aAt the conclusion of the process, the board will consider an control premium.agreement establishing the terms of the sale. Under Delaware ■ A controlling stockholder’s preferences for the transaction (forlaw, the board of a company that wishes to merge with another example, cash versus stock, taxable versus tax-free, or timing)entity must adopt a resolution approving a merger agreement differ from the preferences of other stockholders, so that theand declaring its advisability to the company’s stockholders. controlling stockholder is arguably getting a better deal thanSimilar requirements apply to sales of all or substantially all of a other stockholders, even though it receives the same price percompany’s assets. share as other stockholders.Directors want their decisions to withstand any legal challenge For convenience, we use the term “related-party transaction” tothat might be asserted in connection with a sale. Different legal describe both related party and conflict situations.standards might apply to such a case; Revlon duties are discussedabove. Some board decisions will be subject to “business judgment” From the board’s perspective, a critical difference between areview. The business judgment rule establishes a presumption that typical transaction and a related party transaction is that, when thedirectors, in making a business decision, acted on an informed company is considering a related party transaction, the board mustbasis and in good faith. If the business judgment rule applies, the step out of its role of oversight and governance and play a moredirectors’ decision will be sustained if it can be attributed to a active role in the deal. In a related party transaction, managementrational business purpose, even if, with the benefit of hindsight, the or a controlling stockholder is on one side of the table. The board –decision proves to have been unfortunate. The business judgment typically through a special committee – is literally on the other siderule will not apply if the directors’ decision involves self-dealing or of the table, actively representing the interests of stockholders.a conflict of interest, and the business judgment rule will apply only In a related party transaction, or in evaluating a transaction thatif directors act with due care – the business judgment rule does not involves a conflict, the board should form a special committeeprotect gross negligence. comprised solely of independent directors. (It is helpful if theIn connection with a sale of the company, a board typically committee consists of two or more directors.) The resolutionsrequests a “fairness opinion” from a financial advisor. A sell-side establishing the committee should grant the committee broadfairness opinion is an opinion as to whether the consideration to power, including the power not to recommend any transaction.be received in a proposed transaction is fair, from a financial point The committee should have the authority to retain independentof view, to a company’s stockholders. The opinion is typically advisors, including legal and financial advisors of the committee’saccompanied by a presentation that assesses the value of the choosing. The financial advisor’s compensation should nottransaction, using several methodologies. be entirely contingent on the completion of a transaction. The members of the committee should stay informed and be diligent;Fairness opinions, together with presentations by management the committee should zealously represent its constituents andand the board’s advisors, and the board’s own knowledge of should vigorously negotiate the terms of any deal.the company, its industry, and its prospects, provide the keyfoundation for directors’ exercise of due care and their informed, Conclusion ■ ■ ■careful review of a proposed sale. The board’s active oversight of The board’s principal responsibility is to protect and enhancethe sales process and its instructions to management and advisors stockholder value. Mergers and acquisitions offer one way thatthroughout the process should focus on ensuring that the directors stockholder value can be increased.obtain the best deal reasonably available for stockholders. The board’s principal role is strategy, oversight, and governance.Related-party Transactions ■ ■ ■ Except in the unusual case of a related party transaction, where theRelated-party and conflict transactions provide a contrast to the board must plan an active role in negotiating the deal, the board’stypical buy- and sell-side situations, described above. Related- role in M&A is consistent with its responsibilities for strategy,party transactions include any transaction with, but particularly a governance, and oversight.sale of the company to, a controlling stockholder, management, or On the buy-side, the board should make a number of strategican entity affiliated with a controlling stockholder or management decisions before the company undertakes acquisitions, and(including a buyout in which management is participating). the board should review proposed acquisitions from a strategicConflicts of interest, or possible conflicts, can arise from many perspective with a particular focus on the assumptionscircumstances, including: that underlie the deal and the importance of integrating the acquired business.©2010 6 ©2010
  9. 9. On the sell-side, particular where the board is considering the saleof the company, the board should assess the timing and adopt aprocess. The board should stay actively involved throughout theprocess, overseeing management and the company’s advisors.At the conclusion of the process, the board should assess theproposed agreement and determine whether to recommend it tostockholders. Throughout, directors should act carefully and on aninformed basis.By properly exercising their responsibilities, and providing theadvice and perspective that can come only from directors, theboard can help increase stockholder value, reduce tension withinthe organization, and mitigate litigation risk.Jeffrey S. Phillips is a Managing Director in the Valuation & FinancialOpinions Group at Stout Risius Ross (SRR) where he leadsSRR’s Transaction Advisory Services practice. He has extensiveexperience in providing transaction and valuation opinionsinvolving Fortune 500 and middle market companies. Mr. Phillipscan be reached at 703.848.4955 or jphillips@srr.com.Michael J. Levitin, Esq. is a Partner in WilmerHale’s corporatepractice group, with extensive M&A experience. He is also anadjunct professor at Georgetown University Law Center, wherehe teaches a seminar on international mergers and acquisitions.Mr. Levitin can be reached at 202.663.6163 or michael.levitin@wilmerhale.com. Thomas J. Hope, CFA Resources for Corporate, M&A, and Securities Attorneys thope@srr.com 646.807.4223 Our services include: ■ Mergers & acquisitions advisory ■ Private market financing (debt and equity) ■ Corporate strategic alternatives and succession planning ■ Fairness opinions ■ Solvency and capital adequacy opinions ■ Merger exchange ratio determinations ■ Litigation advisory related to: ■ Dissenting shareholder actions ■ Minority oppression actions ■ Shareholder and commercial disputes ■ Post-transaction purchase price disputes©2010 7 ©2010
  10. 10. M&A and Financing Market Update Terrel G. Bressler – tbressler@srr.com David E. West – dwest@srr.comMarket Activity General economic uncertainty and an anemic ■ Greater bank credit availabilityrecession recovery continue to affect the overall US M&A deal ■ Abundant supplies of private equity capital in theenvironment. Clearly, during the first two quarters of 2010 the financial buyer communityM&A market showed modest improvement from the depthsexperienced in the “dark days” of 2009. Both M&A dollar volume ■ Almost $2 trillion of cash on the balance sheets ofand number of deals showed gradual monthly improvement. public strategic buyers ■ Generally improving earnings of potential sellers as theyDuring the first half of this year most deal market professionals rolled off “bad” months or quarters of 2009 earningswere very enthusiastic about the M&A markets’ prospects for2010. All of the ingredients for an improving deal market seemed ■ Motivated sellers who haveto be in place. been waiting for a liquidity event since late 2008 Overall, the early 2010 deal market M&A Deals Between $1 Million and $500 Million pipeline, measured anecdotally by new business proposal activity, appeared $140 1,000 900 to be filling. However, as of June 2010, Number of M&A TransactionsM&A Deal Volume ($ billions) $120 800 the anticipated new deal volume has $100 700 yet to materialize. In fact, according to 600 Dealogic, early readings of year to date $80 500 Global M&A deal activity through July $60 400 2010 were only marginally ahead of the $40 300 deal flow for the same period last year. 200 $20 100 $0 0 Oct 08 Oct 09 Jul 08 Jul 09 Apr 08 Apr 09 Apr 10 Jan 08 Jan 09 Jan 10 M&A Deal Volume Number of M&A Transactions Source: Factset©2010 8 ©2010
  11. 11. Economic uncertainty and a lack of visibility for corporate Financing Markets ■ ■ ■earnings will probably serve to reduce the level of M&A forthe rest of 2010. The credit markets have evidenced significant positive trends for larger middle market borrowers with a modest easing ofValuations M&A deal valuations improved modestly from the credit metrics for smaller borrowers, but continue to constrainvaluation trough experienced in 2009. transaction activity. We expect modest, but favorable, progress in lender and investor appetite Average U.S. Strategic Middle Market Transaction Multiples for the balance of 2010. We have seen material improvement in 10.0x 9.5x 8.8x 9.2x pricing for solid borrowers and 9.0x 8.5x 8.4x 7.7x a moderate relaxation in credit 8.0x 7.3x 7.5x 7.5x 7.0x 7.0x metrics for borrowers with greater 6.0x than $15 million of EBITDA. 5.0x 4.0x Mezzanine investors have begun 3.0x to selectively consider investments 2.0x in cyclical issuers. We believe 1.0x these trends will emerge over the 0.0x next three to six months. 2003 2004 2005 2006 2007 2008 2009 IH09 2H09 1H10 Source: Thomson Financial Senior Bank Debt Middle market loan issuance was $33.0 billionImprovement in the commercial banking sector resulting in a in the second quarter, up 47.3% from the same time period ofgreater access to financing, better quality sellers, and increased 2009. The 2010 YTD issuance was $55.4 billion, up 91% fromcompetition (the law of supply and demand) for the deals have the same time period of 2009. According to Reuters Loan Pricinghelped support valuations. Another factor in these increased Corporation, lenders were more aggressive in seeking loanvaluation multiples may be the increased use of forward or opportunities than in the first quarter of 2010, however, much ofannualized earnings to “price” companies. In many cases, a the lending was attributed to refinancing. For companies with lesscompany’s trailing 12 month earnings or cash flow was seriously than $15 million of EBITDA, overall market conditions were stillaffected by the recession and not a true indicator of a company’s characterized by higher pricing, more conservative structures,“steady state” earnings potential. In the current environment, lower leverage multiples, and tighter covenants than for companiesforward, or annualized earnings, and cash flow measures were with more than $15 million of EBITDA. Although the credit marketsused instead as this was a better proxy for a company’s steady began to open up in the first half of 2010, we believe issuance willstate earnings potential and its steady state valuation. This resulted still recover at a moderate pace for the remainder of 2010.in an acceptable value to the seller anda higher valuation multiple whencompared to the company’s actual Median EV / LTM EBITDA LBO vs. Strategictrailing earnings. 14.0xRecent valuation data seems to indicate 12.0xthat strategic buyers paid slightly 10.0x EV/LTM EBITDAmore than financial buyers for similarcompanies. The data indicates that 8.0xthe strategic buyer is now paying on 6.0xaverage 0.75x to 1.00x cash flow morethan the financial buyer community. 4.0x 2.0xLarge balances of cash held bystrategic buyers, increased competition 0.0xfor deals, and the desire by strategicbuyers to increase revenue and Number of Trailing Quarters from 2Q 2010 Number of Trailing Quarters from 2Q 2010earnings growth for the next economic LBO Strategicupturn all contributed to increased Source: Capital IQaggressiveness from the strategicbuyer community.©2010 9 ©2010
  12. 12. Pricing and terms for a particular borrower are a function of specific High Yield Bonds High yield debt issuance for 2010 YTD increasedfacts and circumstances. However, in general, we are seeing the substantially versus 2009 YTD volume. Issuance totaled $106.2following broad bank lending market conditions: billion for 2010 YTD, nearly doubling the $58.3 billion in volume completed in 2009 of the same time period.Over $15 million in EBITDA Borrowers(club or non-broadly syndicated deals) Private Equity According to Buyouts, there were 266 control-stake private equity transactions in the first half of 2010, an increase■ 3x to 4x senior debt / EBITDA and 4x to 5x total debt / of 13.7% versus the 234 transactions completed in the first half EBITDA levels of 2009. Total reported deal value for the first half of 2010 was■ Cash flow pricing of: (i) 1% to 2% up front; (ii) 350 to $21.8 billion, an increase of 118.0% from the total of the same time 600 bps credit spread; and (iii) 0% to 1% LIBOR floor period of 2009. The moderate resurgence in fundraising in 2010 coupled with the low level of transaction activity in 2009 allows■ Asset based pricing of: (i) 0.25% to 0.50% up front; private equity firms to have a healthy amount of capital to put to (ii) 175 to 350 bps credit spread; and (iii) generally no work for the remainder 2010. LIBOR floorUnder $10 million in EBITDA Borrowers Initial Public Offerings The U.S. IPO market has been weak since(club or non-broadly syndicated deals) early 2008, but began to show signs of recovery in the first half of 2010. According to Bloomberg, 83 IPOs were priced in the first■ 2.5x to 3.5x senior debt / EBITDA and 3.0 to 4.0x total half of 2010 versus 24 IPOs in the first half of 2009. Total proceeds debt / EBITDA levels came in at $12.87 billion in the first half of 2010, up 278.5% from■ Cash flow pricing of: (i) 1.5% to 2.5% up front; (ii) 400 to $3.40 billion raised in the first half of 2009. 700 bps credit spread; and (iii) 1% to 2% LIBOR floor Economic Conditions ■ ■ ■■ Asset based pricing of: (i) 0.50% to 1.00% up front; (ii) 225 to 400 bps credit spread; and (iii) no LIBOR floor ■ The Fed continues to keep interest rates at historic lows to a 1% LIBOR floor ■ The Fed continues to keep liquidity in the financial system by maintaining the size of its investment in treasuries andPrivate Placements Traditional private placement volume for the mortgage backed securitiesfirst half of 2010 came in at $20.5 billion, up 46.3% from the sametime period of 2009 total of $14.0 billion. Many issues were upsized ■ Unemployment remains stubbornly high at 9.5% with littlewith circled spreads tightening from initial price talk. prospect of declining anytime soonMezzanine Since the beginning of 2010, nearly $4.4 billion of ■ There has been little growth in private sector employmentmezzanine funds were raised, showing promise from the dismal$3.0 billion raised in all of 2009. All-in return requirements are The US economy continues to struggle and there is growinghighly sensitive to company size and exposure to cyclical factors. evidence that the recovery may actually be slowing and is “moreGenerally speaking, non-cyclical to modestly cyclical issuers with modest” than anticipated. The economy does not appear to have$15 million of EBITDA are seeing all-in investor return requirements achieved the “Escape Velocity” that Larry Summers, the Obamaof 14% to 18% with a selective return to all-coupon structures. Administration’s Chief Economist, referred to in April 2010 to moveIssuers with between $10 million and $15 million of EBITDA the economy back on a strong growth track.are seeing all-in return requirements of 16% to 20% with someupside component. For companies in the $5 million to $10 million While many large public companies have posted strong secondEBITDA range, investor return requirements range from 18% to quarter results in July, there is still a lack of business confidence in22% including an upside component and for companies with less the direction of the economy which is preventing many companiesthan $5 million of EBITDA, the range is 20% to 24%, including an from expanding their factories and adding jobs. This is reflected inupside component. The National Federation of Independent Businesses Index of Small Business Optimism which fell to 88.1 in July from 89.0 in June, theInvestment Grade Bonds According to Thomson Reuters, second monthly decline this year.investment grade volume for 2010 YTD was $318.9 billion, a16.9% decrease from the $383.8 billion issued during the same Consumers are similarly worried and have pulled back on spendingperiod in 2009. The number of issues decreased 7.6% to 339 in and have increased their savings rate. After three consecutive2010 YTD from 367 in 2009 during the same time period. Activity is months of increases The Conference Board Consumer Confidenceexpected to increase as many issuers take advantage of historically Index declined to 52.9 in June, down sharply from 62.7 in May.low yield levels. Until there is greater economic certainty for both businesses and consumers we may be in a low to no growth economy for some time.©2010 10 ©2010
  13. 13. Conclusion ■ ■ ■Deals are being consummated despite the uncertain economicenvironment. Creativity and a carefully thought out strategyare essential to achieving a well executed M&A or Financingtransaction. Uncertainty is unlikely to materially diminish nearterm, however, the November elections may provide some clarityand stability with respect to economic and regulatory direction.Terrel G. Bressler is a Managing Director in the Investment BankingGroup at Stout Risius Ross (SRR). He has originated a wide varietyof M&A and capital raising assignments and has assisted numerousmiddle market companies and their shareholders with mergers,acquisitions, raising debt, mezzanine and equity capital, and otherinvestment banking transactions. Mr. Bressler can be reached at312.752.3359 or tbressler@srr.com.David E. West is a Managing Director in the Investment BankingGroup at Stout Risius Ross (SRR). He has a broad range oftransaction experience involving primarily middle marketcompanies, including mergers and acquisitions advisory, raisingdebt, mezzanine and equity capital and other investment bankingtransactions. Mr. West can be reached at 312.752.3306 ordwest@srr.com.©2010 11 ©2010
  14. 14. Guest Article The Benefits of Mezzanine Financing for Middle Market Companies Patrick Rond – prond@kppinvest.com Nicholas Stone – nicks@kppinvest.com Key Principal PartnersRecent market conditions have re-established mezzanine ■ Subordinated debt is comprised of a current interestfinancing’s appeal as a tax-efficient source of long-term capital. coupon, payment in kind (PIK), and warrants.With the reduction of traditional senior bank credit and the ■ Preferred equity is junior to subordinated debt andreluctance of banks to lend under the lenient terms and low viewed as equity from those more senior in therates offered over much of the last decade, mezzanine is one of capital structure.the more effective vehicles for owners of closely held privatecompanies interested in facilitating liquidity for wealthdiversification or succession purposes, pursuing acquisitions, or Mezzanine Capital: Example Capital Structurefunding organic growth.Mezzanine Financing and Common EquityCapital Structure ■ ■ ■Mezzanine, or junior capital, financing is the portion of acompany’s capital that sits between senior debt and common Preferred Equity Return Mezzanine Capitalequity in the form of subordinated debt, preferred equity, or or Junior Capital Subordinated Debtsome combination of these two securities. While mezzaninefinancing can be structured in a number of ways, commoncharacteristics include: Senior Debt■ Subordinate to senior debt in terms of payment priority, mezzanine is senior to common equity.■ Unlike bank loans, junior capital is typically unsecured and commands a higher yield than senior debt. Subordinated debt characteristically has a fixed interest rate or■ There is no principal amortization. coupon as well as a small equity component, and typical returns■ A portion of the return is fixed making this class of range from the mid-to-high teens. Preferred equity returns are security less dilutive than common equity. naturally higher than subordinated debt and often include a fixed return coupled with equity or equity-like instruments.©2010 12 ©2010
  15. 15. Common Uses for Mezzanine Finance ■ ■ ■ Ownership Transition ExampleShareholder Liquidityand Intergenerational Transfer ■ 5x Active Shareholders Minority shareholders boost Active Shareholders / Management Team equity from 40% to 85%Reallocating assets to diversify an owner’s holdings / Management Team 4x Ownership = 40% through a leveraged Ownership > 85% recapitalizationEntrepreneurs and family held businesses often reinvest free Multiple of EBITDAcash flow back into their companies over time and, as a 3xresult, shareholders find that a majority of their personal net Mezzanine Capital Mezzanine Capital 1.5x EBITDA 1.5x EBITDAworth is encumbered by the business. Mezzanine financing Ownership < 15% Ownership < 15% 2xcan be an effective way to fund a one-time dividend, Inactive Shareholder Ownership = 60%providing liquidity for this past reinvestment and diversifying Senior Debt Senior Debtan owner’s holdings. 1x 2.0x EBITDA 2.0x EBITDAWhile many senior lenders, even today, are open to lending Pre-Transaction Leveraged Recapitalization Post-Transactionagainst collateral to provide for a shareholder dividend, rarely is **Please note that the example above is hypothetical and is intended for illustration purposes only**it without restrictions or personal guarantees. Once mezzaninefinancing has been introduced as part of the capital structure,senior lenders often accept the junior capital as a long-term The Ownership Transition Example illustrates how this type ofequity oriented security making it possible for the owner to avoid transaction is affected. Assuming an initial debt-free balancethe personal guarantee requirement. sheet and total leverage of 3.5x earnings before interest, taxes, depreciation, and amortization (“EBITDA”) at close, the inactiveThis small but significant change in the capital structure provides shareholder receives a 5.8x EBITDA valuation for his or her 60%owners with an attractive way to leverage a company, take a ownership position, leaving the active shareholders or managementmeaningful dividend, and mitigate risk. The capital received team with an ownership position equal to or exceeding 85%.by owners can be used to diversify their holdings and increaseallocations in other investments, establish a family trust or other Since mezzanine debt is less dilutive and less expensive thantax advantageous structure to prepare for future estate needs, equity, it allows the remaining shareholders to increase theirand most importantly, safeguard the wealth they have created original equity stake and naturally leverage their return.by establishing assets unrelated to the company, its creditors, or Distributions prior to the scheduled increases intraditional market risks inherent in the business. long-term capital gainsOwnership transition There is a current timing wrinkle that encourages owners to moveWhen shareholders in a privately held company are interested quickly if they are considering taking capital out of a business. Asin personal liquidity, most view their only option as a sale of the part of the 2005 Tax Increase Prevention and Reconciliation Act,company. While a shareholder seeking liquidity may consider the which extended the terms of the original 2003 Tax Act until theoption of selling his or her equity to other existing shareholders end of 2010, long-term capital gains tax rates were reduced fromor the management team, rarely do either of these latter groups 20% to 15% for the highest tax brackets. Under the federal budgethave the personal assets available to finance the purchase of proposed for 2011, these tax cuts will be allowed to expire and thethe company. Mezzanine financing can facilitate the transition original, higher rates will prevail.of ownership in these scenarios without the need for seller Additionally, the recently passed health care reform legislation callsfinancing or other expensive equity alternatives. In order to affect for another tax on investment income of 3.8% for couples earningthis type of transaction: more than $250,000 in annual income beginning in 2013, bringing■ The owner agrees to sell his or her portion of the the effective rate to 23.8%. business to family members, other existing shareholders, Therefore, owners planning to take capital out of a business may or the management team. want to move quickly to avoid these tax consequences. Since a■ The company borrows a combination of senior debt and sale of the company to a strategic buyer or institutional investor mezzanine capital. can take three to nine months, a dividend recapitalization utilizing■ The capital proceeds created by the combination of mezzanine financing may be one of the few options available to senior debt and mezzanine are then used to buy out the shareholders interested in liquidity prior to the end of 2010. inactive shareholder at a fair market value, leaving active shareholders or the management team as the company’s controlling shareholders.©2010 13 ©2010
  16. 16. Acquisition Financing ■ The Acquisition Finance Illustration compares two strategies, a commitment to the status quo versus expansion through For companies looking to grow through acquisition, the last few acquisition. Each case assumes a sale of the company at years have presented an unusual confluence of circumstances: the end of the fifth year. While no credit is given for post acquisition efficiencies or economies of scale in the Acquisition ■ Many companies were adversely affected by the scenario, the valuations at T0, inclusive of the add-on acquisition, economic slump, which resulted in dampened profitability are assumed at 6.0x EBITDA, and the exit valuations at T5 and naturally depressed valuations. This chain of events are assumed at 7.0x EBITDA. has many equity owners, once with unrealistic valuation expectations, now willing to consider a liquidity event with By using mezzanine capital to expand through acquisition, the reasonable terms. equity value in year five is 18% higher than in the status quo case, ■ Due to a lack of transaction activity since mid-2008 underscoring the net benefit to the common equity holders. This coupled with the number of aging shareholders searching further illustrates that mezzanine capital is a cost-effective solution for ways to exit their businesses, the number of for expansion-minded companies seeking alternatives to raising companies that will be sold over the next few years is outside equity. expected to swell. Growth Capital ■ ■ Financing for acquisitions made by privately held companies has been especially tight. As evidenced over Mezzanine capital can also be particularly suitable for companies the past 24 months, banks have pulled back from M&A that have established themselves but lack access to commercial lending, and the covenants for loans that are made have paper or the global funding sources of large corporations. The become far more rigid. This credit tightening is most advantages of mezzanine to finance capital expenditures to pronounced for lower middle market companies. support increased capacity, research and development, or new market expansion are the same as for other applications: it’s In summary, while more accretive acquisitions will likely be available cheaper than equity and offers more flexible terms and covenants to strategic buyers at reasonable prices, bank lending capacity to than senior debt. complete these acquisitions has been significantly constrained The Benefits of Mezzanine Capital ■ ■ ■ and appears to change day to day. Non-amortizing, resulting in improved cash flows Owners are then faced with foregoing the acquisition or raising outside capital to support the theoretical “gap” in the Senior debt usually has a highly structured amortization schedule capital structure. with relatively short maturities, often no more than three years for privately held companies. Most junior capital securities have longer maturities, usually five to Acquisition Finance Illustration seven years, with the principal paid at maturity.(MM) Because mezzanine financing does not require All T 0 assets valued at 6.0x EBITDA. TEV: $134.0 130 All T 5 assets valued at 7.0x EBITDA. amortization during the term of the debt, 120 EBITDA growth of 5% per year. companies are able to use the increased cash Equity Value: $122 No benefit was assumed for post acquisition efficiencies. flow to: (i) pay down senior debt, (ii) invest 110 in working capital, product development, or TEV: $103.2 100 Cash (Net of Debt): other expansion, or (iii) accumulate the cash on 90 $13.8 TEV: $90 the balance sheet to take advantage of future Equity Value: $45M unforeseen opportunities. 80 Equity Value: $89.3 Source of flexible long-term capital 70 TEV: $60 60 Base EBITDA: $10 As a rule, mezzanine financing offers significantly 50 Equity Value: $35 Total EBITDA: $15 more flexibility in coupon structure, terms, and amortization than banks and senior debt 40 Mezzanine providers. A mezzanine investment can easily 30 1.5x EBITDA be tailored to a company’s particular financial 20 EBITDA: $10 EBITDA: 12.8M EBITDA: $19.2 situation and concerns. Unlike a traditional bank Senior Debt loan, mezzanine capital is unsecured and thus, 10 Debt: 1.5x EBITDA 1.5x EBITDA Debt: 0.6x EBITDA requires no readily marketable collateral. Because T0 Status Quo T5 T0 Acquisition T5 mezzanine investors are more equity oriented than **Please note that the example above is hypothetical and is intended for illustration purposes only** ©2010 14 ©2010
  17. 17. senior lenders, they tend to be more amenable to customizing their Mezzanine Financing – Filling a Niche forinvestment to meet the borrower’s financial, operating, and cash Middle-Market Companies ■ ■ ■flow needs. According to Thomson Reuters, over $25 billion has been raisedA less expensive, tax-advantageous alternative to equity by limited partnership mezzanine funds since 2008, evidence that the mezzanine financing market is mature, well developed,Mezzanine capital, when utilized in conjunction with senior debt, and accessible for issuers. Again, no single type of financing isreduces the amount of equity required in a business. Since appropriate for every instance. There are cases where mezzaninecommon equity is the most expensive form of capital and is not tax financing may not be available to a company, but for well-manageddeductible, mezzanine debt can create a more efficient structure companies with strong cash flow and good business prospects,that lowers the after-tax cost of capital, is less dilutive than equity mezzanine financing can be a smart solution for a variety offinancing, and enhances the return on equity. liquidity or expansion needs.Mezzanine financing offers other benefits to companies focused Patrick Rond and Nicholas Stone are investment professionalson optimizing their capital structures and expanding access to at Key Principal Partners Corp., a $1.2 billion private equityfunding. Since mezzanine capital providers take a long-term view and mezzanine fund with offices in Cleveland, Greenwich, andof a company, banks may look at firms with institutional investors San Francisco. KPP makes investments of $10 - $40 million perin a more positive way, extending credit with more attractive transaction and has the flexibility to structure its investmentsterms and relinquishing the need for personal guarantees. as subordinated debt, preferred stock, and common equity.Additionally, mezzanine investors help diversify a company’s Mr. Rond can be contacted at 216.828.8138 or prond@kppinvest.funding relationships, reducing dependence on any one investor com, and Mr. Stone can be contacted at 415.439.5371 or nicks@or lender. kppinvest.com (www.keyprincipalpartners.com).Considerations in Mezzanine Financing ■ ■ ■Of course, no single type of funding is perfect for every situation,and borrowers need to make sure that the lenders and termsare right for them. In addition, there may be certain businessor transaction characteristics which make it difficult to utilizemezzanine financing. These attributes may include but are notlimited to the following:■ High customer concentration■ Capital expenditure intensive business■ Lack of management■ Commodity-like products or services■ Cyclicality resulting in volatile cash flow■ A current debt to EBITDA ratio close to or exceeding the market value of the company©2010 15 ©2010
  18. 18. Dividend Recaps: Trends and the Importance of Solvency Opinions Aziz El-Tahch, CFA – aeltahch@srr.comAfter peaking in 2007, private equity transactional activity crashed Dividend Recaps ■ ■ ■alongside the credit markets in 2008 and 2009. Accordingto PitchBook, a research firm, the total amount of private Simply put, a dividend recap is the process of using borrowedequity capital invested in the United States declined from over money to issue a special dividend to a company’s private equity$600 billion in 2007 to approximately $200 billion in 2008 and investors. Private equity firms benefit from this type of transaction$60 billion in 2009.1 for numerous reasons:In late 2009, however, private equity activity ascended from its ■ A dividend recap enables the private equity firm tomid-2009 nadir. In the fourth quarter 2009 and the first half 2010, achieve partial liquidity earlier than an initial publicthere were 985 reported deals worth a combined $80 billion – offering or the outright sale of a portfolio company,a significant improvement from the 889 deals worth a combined which increases the private equity company’s internal$33 billion in the first three quarters of 2009.2 Not surprisingly, the rate of return on the investment.increase in private equity activity coincided with an improvement ■ A dividend recap does not dilute the private equity firm’sin the lending environment. Average lending multiples for private ownership of a portfolio company, which allows theequity acquisitions increased from 3.9x EBITDA in the fourth private equity company to maintain operational controlquarter 2009 to 4.1x in the first quarter 2010, with some banks and capture the full benefit of future growth.even lending up to 5.0x EBITDA.3 ■ A dividend recap enables the portfolio companyThe improvement in the credit markets in late 2009 also led to to benefit from the “tax shield” attributable to thethe revival of a seemingly forgotten vestige of private equity’s tax deductibility of interest payments on theheyday – leveraged dividend recapitalization transactions, more newly-issued debt.commonly known as “dividend recaps.” 1 Private Equity Investment Trends – 3Q 2010 (PitchBook, 2010). 2 Ibid. 3 Private Equity Investment Trends – 2Q 2010 (PitchBook, 2010).©2010 16 ©2010

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