Pepperdine cost of capital national summit 10 18 2011

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New insights and data on pricing capital in today’s competitive environment from the Pepperdine Private Capital Markets Project show challenges remain for lenders, investors and the private business that depend on them. Lead researcher John Paglia presented at the National Summit for Middle Market Funds.

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Pepperdine cost of capital national summit 10 18 2011

  1. 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. 2. Dow Jones Industrial Average (2007 – 2011)
  3. 3. Dow Jones Industrial Average (2007 – 2011)
  4. 4. Dow Jones Industrial Average (2007 – 2011)
  5. 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. 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. 7. Pepperdine Private Cost of Capital Line Expected Returns by Capital Providers on New Investments Fall 201170% 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. 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. 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. 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 5Source: Pepperdine Private Capital Markets Project Fall 2011 Business Owner Survey, Pepperdine University
  11. 11. What is the Status ofPrivately-Held Businesses as of Fall 2011?
  12. 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. 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 strategiesSource: Pepperdine Private Capital Markets Project Fall 2011 Business Owner Survey, Pepperdine University
  14. 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 OtherSource: Pepperdine Private Capital Markets Project Fall 2011 Business Owner Survey, Pepperdine University
  15. 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. 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. 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. 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 cardLess 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. 19. Persistence Pays… Average Number of Capital Providers Contacted for Successful Financing Outcome6.0 5.35.0 4.8 4.04.0 3.6 3.4 3.23.0 2.4 2.4 2.3 2.3 2.02.01.00.0 Source: Pepperdine Private Capital Markets Project Fall 2011 Business Owner Survey, Pepperdine University
  20. 20. Business Owners’ Expected Time to Exit (>$5 million revenues) 0.3 25% 0.25 23% 0.2Percentage (%) 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. 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. 22. What’s Happening with Capital Providers?
  23. 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. 24. Banks: Loan Sizes Underwritten60% 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 $50MLargest concentrations of loan sizes were between $1 millionand $25 million
  25. 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 OtherRefinancing accounted for nearly 49% of all lending activityfollowed by expansion (22%), working capital (11%)
  26. 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. 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 3.4Approximately 1.5X – 2.5X under $25M in EBITDA; 3X andabove greater than $25M
  28. 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 3.5Approximately 1.8X – 2.5X under $25M in EBITDA; 2.5X andabove greater than $25M
  29. 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 6.5Rates correspond to loan terms of 60 months (median)Slight increase in all-in-rates on cash flow loans over the last6 months, except for large companies
  30. 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. 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
  32. 32. What’s Happening withAsset Based Lenders?
  33. 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. 34. ABLs: Loan Sizes Underwritten60%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 $500MLargest concentrations of loan sizes were between $1 and $5million (48%)
  35. 35. ABLs: Motivations Refinancing 5% 13% Finance worsening operations  13% conditions 55% Fluctuating working capital 17% Expansion OtherRefinancing accounted for nearly 55% of all lending activityfollowed by worsening operations conditions (13%) andworking capital (13%)
  36. 36. ABLs: Advance Rates Typical Loan  (Median %) Upper Limit (Median %)  Spring  Fall 2011 Spring 2011 Fall 2011 2011Marketable securities 80 90 90 90Accounts Receivable 80 85 85 85Inventory ‐ Low quality 25 25 40 30Inventory ‐ Intermediate  40 45 50 50qualityInventory ‐ High quality 55 60 60 60Equipment 60 75 80 75Real Estate 60 65 70 70Land 50 40 50 42On average, advance rates are slightly higher than 6months ago
  37. 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. 38. ABLs: All in Rates (%)Type and Size  1st Quartile  Median  3rd Quartile  Spring  Fall  Spring  Fall  Spring  Fall  2011 2011 2011 2011 2011 2011WORKING 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 3.1EQUIPMENT$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 2.5All-in-rates are lower than 6 months ago except smallsize lending with working capital as a collateral
  39. 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. 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. 41. What’s Happening with Mezzanine Capital?
  42. 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. 43. Mezzanine: Loan Sizes Underwritten70%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 $500MLargest concentrations of loan sizes were between $5 and $10million (58%)
  44. 44. Mezzanine: Loan Motivations Acquisition loan 5% 2% Management buyout 15% 29% Refinancing 15% 28% Financing growth Working capital fluctuations Finance worsening operations  conditionsAcquisition loan investments accounted for 29% of activity,followed by MBO (28%), refinancing (15%) and growth (15%)
  45. 45. Mezzanine: To Make One Investment…70 606050 40403020 15 1010 6 8 2 2 0 Plans Reviewed Meetings Proposal Letters LOI Median Average
  46. 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. 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. 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. 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 13Mezzanine interest rates for non-sponsor transactions areslightly lower than 6 months ago
  50. 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. 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 21Mezzanine total returns decreased for almost all loan sizesin the last 6 months
  52. 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 5.5Represents additional 1 – 2 turns of EBITDA (after senior),increasing with size. Relatively constant when compared toSpring 2011.
  53. 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 84Looking to exit in 5-7 yearsExit times are longer than 6 months ago
  54. 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 2011Senior debt service  1.6 1.5 1.3 1.2 3.3 2.4coverage ratio Total debt service  1.3 1.4 1.2 1.2 2.7 3.3coverage ratio Senior debt to cash flow  2.5 2.5 3.0 3.0 3.4 2.9Total debt to cash flow  3.5 4.0 4.0 4.0 3.4 3.6
  55. 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 15Largest concentration of responses indicates plan for 3 – 5transactions in next 12 months (39%); 32% are planningbetween 6 and 10
  56. 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 OtherBusiness services (22%), manufacturing (21%), andhealthcare (14%) look to be areas targeted for investment
  57. 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. 58. What’s Happening with Private Equity?
  59. 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. 60. Private Equity: Investment Activity in Last Six Months 4% 4% 0 7% 26% 1 11% 2 17% 3 31% 4 5 more than 5Nearly 74% of respondents reported making a deal in the last6 months; approximately 26% reported no transactions
  61. 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 millionThe 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. 62. Private Equity: To Make One Investment…160 142140120 100100 80 60 40 22 20 15 5 9 2 2 0 Plans Reviewed Meetings Proposal Letters LOI Median Average
  63. 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  0.3Score (‐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. 64. Private Equity: Difficulty Securing Senior Debt? 3.0 2.5 2.3 2.0 1.8 1.7 1.7Score (‐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. 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 8.5Median deal multiples starting to exhibit weakness
  66. 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 55Median equity contributions reported range from a high of 60%for smaller transactions to 35% for larger companies
  67. 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 27Expected gross annual returns on new investment range from amedian of 25% for most large transactions to 30% for smalleronesExpected returns are significantly lower than 6 months ago
  68. 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 60Expected exit times range from 48 months for largertransactions to 60 months for smaller ones
  69. 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 660% are looking to make 2 – 3 investments in the next year
  70. 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 OtherManufacturing (19%), business services (16%), healthcare(12%), and retail & consumer services (12%) appear to be thetargets of 59% of investments
  71. 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
  72. 72. What are InvestmentBankers Experiencing?
  73. 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. 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 675% report making at least one deal in last 6 months; 51% madebetween 1 – 3 while 25% didn’t make any
  75. 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 monthsThe largest concentration of transactions closed in 6-8 months(29%); another 22% closed in 4-6 months
  76. 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. 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% moreRoughly 19% report that strategic buyers didn’t pay premiumsrelative to financials’ offers; 23% report premiums less than10% and another 28% report premiums between 11-20%
  78. 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 misrepresentations37% report valuation gap of less than 20%; 39% report21 – 30% valuation gap
  79. 79. Investment Bankers: Difficulty 2.5 Securing Senior Debt? 1.9 2.0 2.0 1.6 1.5 1.3Score (‐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. 80. Investment Bankers: Balance of Capital with Businesses Worthy of Financing: 1.5 Surplus or Shortage? 1.0 0.8 0.9 0.7Score (‐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. 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 6Almost half (48%) report an expectation to transact between3 and 5 businesses during the next 12 months
  82. 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. 83. What’s Happening with Limited Partners?
  84. 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. 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. 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. 87. Limited Partners’ Return Expectations on New Investments (%) 25.0 20 20 20 20.0 18 18Gross 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. 88. Importance of Factors When Raising Funds 5 4.5 4.4 4.0 4Importance 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. 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. 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. 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. 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. 93. Thank You! John K. Paglia, Ph.D., CFA, CPA Associate Professor of FinanceSenior Researcher, Pepperdine Private Capital Markets Project bschool.pepperdine.edu/privatecapital john.paglia@pepperdine.edu

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