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State of the Middle Market Today 10.25.10

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Professor John Paglia, lead researcher for the Pepperdine Private Capital Market Project, spoke at the annual meeting of the National Association of Small Business Investment Companies (NASBIC) in …

Professor John Paglia, lead researcher for the Pepperdine Private Capital Market Project, spoke at the annual meeting of the National Association of Small Business Investment Companies (NASBIC) in Palm Beach, Florida. He addressed the National Summit for Lower Middle Market Funds, the premier networking event for lower middle market private equity funds, independent sponsors, investors and service providers. http://bschool.pepperdine.edu/privatecapital

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  • 1. The State of the Middle Market Todayy National Summit for Middle Market Funds October 25, 2010 John K Paglia Senior ResearcherJohn K. Paglia, Senior Researcher, Denney Academic Chair, and Associate Professor of Finance
  • 2. Agenda • Overview of Pepperdine Private Capital Markets Project • Insights from Various Segments• Insights from Various Segments – Banks – Mezzanine – Private Equityq y • The Road Ahead: 12 Month Outlook • Panel Discussion – Tom Hiatt, Centerfield Capital Partnerso att, Ce te e d Cap ta a t e s – Preston Walsh, PNC Mezzanine Capital – Rob Zielinski, Riordan, Lewis & Haden Equity Partners – Greg Greenburg, Altus Capital Partners • Questions and Answers
  • 3. • What is cost of capital for privately-held businesses? Pepperdine Private Capital Markets Project p p y • Project launched in 2007; first semi-annual report published in July 2009 • Survey 12 segments including limited partners, privately-held business owners, capital providers, intermediaries, and appraisers • Typical survey asks about firm profile, behavior, historical returns expected returns view of next 12 monthsreturns, expected returns, view of next 12 months • Capital providers last surveyed in September 2010. Report to be available mid-November at http://bschool.pepperdine.edu/privatecapitalp p pp p p
  • 4. How Are Investments Evaluated in the 90.0% 100.0% 85% 82% 89% 93% Private Markets? 50 0% 60.0% 70.0% 80.0% 76% 49% 66% 20.0% 30.0% 40.0% 50.0% 15% 21% 11% 0.0% 10.0% Payback Internal Rate  of Return  (IRR) Discounted  Cash Flow  (DCF) Multiple  Analysis Market  Analysis Option  Analysis Decision trees Simulation  Analysis (i.e.,  Monte Carlo Scenario  Analysis Gut feel (IRR) (DCF) Monte Carlo  methods)Angel VC PE Mezz Business Average Source: Pepperdine Private Capital Markets Project Survey Report, February 2010
  • 5. Factors (39‐75%) VCs (25‐40%) Angels (30‐60%) Banks  ABLs  (4‐18%) Mezz (18‐22%) PEGs (20‐30%) (3‐6%) ( )
  • 6. Banks: Today vs 6 Months Ago • No increase in business confidence/conditions Banks: Today vs. 6-Months Ago • Demand for loans up but increases in underwriting standards and covenant tightness • Slight decline in standard advance rates and increased• Slight decline in standard advance rates and increased focus on collateral as backup means of payment • Increases in senior and total leverage multiples
  • 7. Banks: Loan Sizes and Motivations 35% 34.9% 34.9% Largest concentrations of 10% 15% 20% 25% 30% 35% 14.3% 27.0% 27.0% 19.0% 14.3% Largest concentrations of  loan sizes were between $1  million and $50 million 38 1% 12.2% 2.5% Refinancing Management buy‐out 0% 5% 10% < $1M $1M ‐ $5M $5M ‐ $10M $10M ‐ $25M $25M ‐ $50M $50M ‐ $100M $100M ‐ $500M > $500M 1.6% 38.1% 10.0% 14.7% 1.1% 14.7% Financing growth Chapter 11 workout Acquisition loan Debtor‐in‐possession Working capital fluctuations Refinancing accounted for nearly  40% of all lending activity followed  by acquisitions (15%) 4.3% 2.4% g p Equipment or building Other by acquisitions (15%)
  • 8. Banks: Senior Leverage Multiples Business Services 1st Quartile Median 3rd Quartile $1M 1.2 1.2 1.9 $5M 2.5 2.5 3.0 Approximately 1.2X – 2.5X under $10M in  $10M 2.5 2.5 3.0 $25M 2.5 3.0 3.0 $50M 2.6 3.0 3.0 $100M 3.1 3.3 3.4 EBITDA; 3X and above  greater than $10M Manufacturing 1st Quartile Median 3rd Quartile $1M 1.3 1.3 2.0 $5M 2.1 2.5 3.0 $10M 2 4 2 5 3 0 Approximately 1.3X – 2.5X under $10M in  EBITDA 3X and above$10M 2.4 2.5 3.0 $25M 2.6 3.0 3.0 $50M 2.5 3.0 3.0 $100M 2.3 3.0 3.2 EBITDA; 3X and above  greater than $10M Generally about ½ turn higher except in $1M (down from 1 5)Generally about ½ turn higher except in $1M (down from 1.5)
  • 9. Banks: All in Rates on Cash Flow Loans Cash flow loan all‐in‐Rate (%) $1 million 1st Quartile 5.4  Median 6.5  3rd Quartile 7 1 Median all‐in‐rates from 5%  to 6.5% depending on size;  3rd Quartile 7.1  $5 million 1st Quartile 5.0  Median 5.5  3rd Quartile 6.0  $10 illi some as low as 3.5%  Rates correspond to loan  terms of 36 months (median)$10 million 1st Quartile 4.5  Median 5.5  3rd Quartile 7.0  $25 million 1 t Q til 3 8 terms of 36 months (median)  within range of 30 – 60  months (1st and 3rd quartile) 1st Quartile 3.8  Median 5.5  3rd Quartile 7.2  $50 million 1st Quartile 3.5  M di 5 0 Rates generally flat except  up 50 b.p. for $1 million Median 5.0  3rd Quartile 7.4 
  • 10. Banks: The Next 12 Months • Sharp increase in demand for loans Banks: The Next 12 Months • Underwriting standards slightly more stringent while credit quality of borrowers continues to improveimprove • Further increases in senior/total leverage multiples • Collateral remains in focus • See confidence and conditions improving
  • 11. Mezzanine: Today vs 6 Months Ago • Demand for business investment up Mezzanine: Today vs. 6-Months Ago • Increases in investment standards, credit quality of borrowers, appetite for risk • Deal senior leverage and total leverage multiples up• Deal, senior leverage, and total leverage multiples up • Time to exit investments slightly longer
  • 12. Mezzanine: Current Activity Nearly 70% of respondents reported making a deal in last 6 months; approximately 30% reported no t ti 30% 4% 5% 9% 2% 4% 2% 2% 0 1 2 3 4 transactions 47.7% 53.8% 24.6% 12 3% 30.0% 40.0% 50.0% 60.0% 14% 14% 14% 5 6 8 10 11 16 or more 0% 4% Refinancing 1.5% 12.3% 6.2% 3.1% 0.0% 10.0% 20.0% 25% 21% 14% 28% 7% Refinancing Management buy‐out Financing growth Chapter 11 workout Acquisition loan Most investments in $1 million to $25 million range; Acquisition loan investments accounted for 28% of activity, followed by 14% 1% Debtor‐in‐possession Dividend recap Other refinancing (25%) and MBO (21%)
  • 13. Mezzanine: Pricing $1M $5M $10M $25M 1st Q 12 4% 12 0% 12 3% 12 0% $1M $5M $10M $25M 1st Q 13 3% 12 0% 12 0% 11 8% Sponsor Transactions Non‐Sponsor Transactions Interest Rate (%) 1st Q 12.4% 12.0% 12.3% 12.0% Median 13.3% 12.8% 13.0% 12.0% 3rd Q 13.6% 13.0% 13.0% 12.0% 1st Q 13.3% 12.0% 12.0% 11.8% Median 14.0% 14.0% 12.0% 12.0% 3rd Q 14.0% 14.0% 13.0% 12.8% PIK (%) $1M $5M $10M $25M 1st Q 3.3% 2.0% 2.0% 2.6% Median 3.5% 3.0% 2.0% 2.9% 3rd Q 3.8% 4.0% 3.0% 3.0% $1M $5M $10M $25M 1st Q 2.0% 1.0% 2.0% 2.5% Median 2.0% 2.0% 2.0% 3.0% 3rd Q 2.0% 2.0% 2.8% 3.0% Total Returns $1M $5M $10M $25M 1st Q 18.0% 17.5% 17.3% 17.9% Median 20 0% 20 0% 18 9% 18 5% Total Returns $1M $5M $10M $25M 1st Q 23.0% 22.0% 20.0% 17.8% Median 24 0% 22 0% 20 0% 18 0% Total Returns (%) Median 20.0% 20.0% 18.9% 18.5% 3rd Q 22.0% 22.3% 20.0% 19.0% Median 24.0% 22.0% 20.0% 18.0% 3rd Q 24.5% 24.0% 21.3% 18.5%
  • 14. Mezzanine: Total Leverage and Time to ExitMezzanine: Total Leverage and Time to Exit Total Leverage Ratios (x EBITDA) $1M $5M $10M $25M 1st Q 2.9  3.5  3.5  4.4  Median 3.5  3.5  4.0  4.8  3rd Q 4.1  4.0  4.0  5.0  Represents additional 1 – 2 turns of  EBITDA (after senior), increasing with  size; relatively flat from 6 months ago  $25M f 4 5X $1M $5M $10M $25M except $25M up from 4.5X Time to Exit (Months) $ $ $ $ 1st Q 36  48  48  33  Median 48  54  60  36  3rd Q 63  60  60  42  Looking to exit in 3‐5 years
  • 15. Mezzanine Investments: Next 12 Months 5% 2% 2% 11% 2% 4% 2% 5% 7% 4% 0 1 2 3 4 5 Largest concentration of responses  indicate plan for four transactions in  ( ) 29% 13% 14% 5 6 7 8 9 10 12 next 12 months (29%); 56% are  planning between four and six 6.0% 1.4% 0.7%4.2% 1.4% 0.4%1.2% 1.4%2.8% 6.2% Consumer services Restaurant Healthcare Life sciences 12 16 or more Business services (25.4%),  12.2% 3.1% 2.4% 25.4%21.5% 9.1% 0.8% Life sciences Retail Real estate Business services Manufacturing Wholesale and distribution Finance, insurance, and related Information and technology M di d t t i t manufacturing (21.5%), and  healthcare (12.2%) look to be areas  targeted for investment;  manufacturing down from 27 8% Media and entertainment Agriculture and mining Engineering and construction Transportation Oil, gas, and other utilities manufacturing down from 27.8% 
  • 16. Mezzanine: A View to the Next 12 Months • See increases in demand for business investment credit Mezzanine: A View to the Next 12 Months See increases in demand for business investment, credit quality of borrowers up, increasing appetite for risk, and investment standards stabilizing • Deal, senior leverage, total leverage multiples increasing further • See size of industry increasing• See size of industry increasing • Sees improvement in returns Last 12  months  Next 12  months 1st Quartile 7.3% 12.0% di % %Median 15.0% 18.0% 3rd Quartile 19.3% 22.0%
  • 17. P i t E it T d 6 M th APrivate Equity: Today versus 6 Months Ago • Demand for business investment is up as are investmentDemand for business investment is up, as are investment standards, appetite for risk, and quality of companies seeking investment • Leverage and deal multiples increased; exit times longer • Increased ability to assess and price risk • General contraction in size of industry• General contraction in size of industry • Communication with and power of LPs has increased
  • 18. Private Equity: Current Activity 32.7%6.1% 3.4% 3.4% 1.4% 0.7% 0.7% 1.4% 2.0% 0.7%1.4% 0 1 2 3 Nearly 68% of respondents reported making a  d l i l t 6 th i t l 33% 21.1% 25.2% 4 5 6 7 8 deal in last 6 months; approximately 33%  reported no transactions 9 10 12 16 or more 50 0% 43.5% 10 0% 20.0% 30.0% 40.0% 50.0% 3 1% 25.9% 30.6% 43.5% 31.6% 21.8% 10.4% 4.7% The largest concentration of checks  written was in the $10 ‐ $25 million  range (43.5%) followed by $25 ‐ $50  million (31.6%) and $5 ‐ $10 million 0.0% 10.0% < $1M $1M ‐ $5M $5M ‐ $10M $10M ‐ $25M $25M ‐ $50M $50M ‐ $100M $100M ‐ $500M > $500M 3.1%million (31.6%) and $5  $10 million  (30.6%)
  • 19. Private Equity: Deal Multiples and Equity C t ib tiContributions EBITDA  1st  Median 3rd  Median equity Quartile Quartile $1M 38.8% 60.0% 82.5% $5M 40.0% 60.0% 70.0% $10M 50.0% 57.5% 61.6% Median equity  contributions reported  range from a high of 60%  for smaller transactions to  $25M 25.0% 47.5% 60.0% $50M 21.3% 32.5% 40.0% $100M 10.0% 20.0% 22.5% 20% for larger companies;  improved > $10 million EBITDA  1st Quartile Median 3rd QuartileQ Q $1M 3.9  4.0  5.3  $5M 4.5  5.0  5.7  $10M 5.0  6.0  7.0  Deal multiples range from a  median of 4X EBITDA to 7.5X for  transactions with $50 million  EBITDA $25M 5.5  6.0  7.8  $50M 7.5  7.5  8.0  EBITDA
  • 20. Private Equity: Expected Returns and Exit TiTimes EBITDA  1st Quartile Median 3rd Quartile Expected gross annual returns on  $1M 25.0% 30.0% 35.0% $5M 25.0% 30.0% 30.0% $10M 24.5% 30.0% 31.3% new investment range from a  median of 25% for larger  transactions to 30% for smaller  ones $25M 25.0% 28.0% 30.0% $50M 22.0% 25.0% 30.0% ones EBITDA 1st  Quartile Median 3rd  QuartileQ Q $1M 48.0  60.0  60.0  $5M 48.0  60.0  60.0  $10M 36.0  48.0  48.0  $25M 37.0  48.0  60.0  $ Expected exit times range from 48 months  for larger transactions to 60 months for  smaller ones $50M 48.0  48.0  60.0  $100M 48.0  48.0  48.0 
  • 21. Private Equity Investing: Next 12 Monthsq y g 4% 9%4% 8% 1% 2% 1% 2%1%1% 3% 0 1 2 3 4 Nearly 2/3 (64%) are looking to make 2 – 4 investments  in the next year and approximately 12% of those will  be in distressed assets (prior was 17 9%) Distressed as a % of total # of transactions 12.3% Distressed as a % of total VALUE of  transactions 10.0% 30% 23% 11% 5 6 7 8 10 12 14 be in distressed assets (prior was 17.9%) 6.0% 1.2% 11.2% 1.8% 2 2% 6.2% 3.3% 1.8% 0.9% 1.6% 1.7% 4.6% 3.6% Consumer services Restaurant Healthcare Life sciences Retail Real estate 15 16 or more Manufacturing (22.7%, from 2.2% 2.3% 16.7% 22.7% 6.3% 6.0% Real estate Business services Manufacturing Wholesale and distribution Finance, insurance, and related Information and technology  Clean / green technology Media and entertainment Manufacturing (22.7%, from  25.5%), business services (16.7%),  and healthcare (11.2%, from 8%)  appear to be the targets of nearly  h lf f ll i t t Media and entertainment Agriculture and mining Engineering and construction Transportation Oil, gas, and other utilities Other half of all investments
  • 22. Private Equity: A 12-Month View • See increases in demand for business investment, standards, quality of companies seeking investment, increasing appetiteq y p g g pp for risk • Greater ability to assess and price risk D l i l t t l l lti l i i• Deal, senior leverage, total leverage multiples increasing further • Communication with and power of LPs increasing furtherp g • More contraction in size of PE industry • See improvement in returns Last 12  months  Next 12  months 1st Quartile 18.0% 22.0% Median 25.0% 27.0% 3rd Quartile 35.5% 35.0%
  • 23. General Survey Insights Across All Segments • What is the #1 issue facing privately-held businesses today? – Limited access to capital (40%) y g g p ( ) – Government regulations (taxes, healthcare, etc.) (30%) – Economic environment / uncertainty (20%) • What is the #1 emerging issue facing privately-held• What is the #1 emerging issue facing privately-held businesses? – Tighter government regulations (35%) Li it d t it l (25%)– Limited access to capital (25%) – Economic environment / uncertainty (14%)
  • 24. General Survey Insights: Private Equity, Mezzanine, • What are the significant trends and developments in private and Venture Capital What are the significant trends and developments in private equity? – Risk aversion / stricter investing requirements (21% mezzanine, 22% venture capital 17% private equity)venture capital, 17% private equity) – Businesses facing lower demand / increasing competition / lower margins (21% mezzanine, 22% venture capital, 17% private equity) Government regulations (12% mezzanine 14% venture capital 17%– Government regulations (12% mezzanine, 14% venture capital, 17% private equity)
  • 25. What about the Businesses? • Compared to six months ago... – Time to collect receivables is up Owner compensation is down– Owner compensation is down – Competitive pressures are up – CAPEX is flat, as are other expenses Opportunities for growth are up sharply but– Opportunities for growth are up sharply, but... – Access to growth capital is down! • Who can help? LPs say PE (48%) and Mezzanine (33%) offer best i k/ t t d ff !risk/return tradeoffs! – PE returns at 17.0% – Mezz returns at 12.1% 11% 33% 48% 8% Venture Capital Mezzanine Investment Private Equity48% Private Equity Hedge Fund
  • 26. The Road Ahead • Economic View – GDP at 1.1% P b bilit f d bl di i t 35%– Probability of double-dip recession at 35% • Industry View – Mezzanine and private equity favorite asset classes – Deal flow increasing – Leverage and deal multiples increasing • Business View – Desperate for growth capital – Many owners still waiting to sell
  • 27. Thank You! John K. Paglia Thank You! John K. Paglia Associate Professor of Finance Senior Researcher Pepperdine PrivateSenior Researcher, Pepperdine Private Capital Markets Project bschool.pepperdine.edu/privatecapital john.paglia@pepperdine.edu

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