Dr. John Paglia, lead research for the Pepperdine Private Capital Project, presented a workshop on his cost of private capital model at IACVA-Germany's Fourth Annual Business Valuation Conference on October 8, 2010 in Munich. http://bschool.pepperdine.edu/privatecapital

1. The Private Cost of Capital ModelIACVA Conference, October 8, 2010 John K. Paglia, Senior Researcher, Denney Academic Chair, and Associate Professor of Finance

2. Questions to Consider Do privately held firms obtain capital from the public markets? Do the majority of privately-held companies go public? Do we have robust sources for obtaining capital in the private capital markets? Do these capital sources price risk in their particular segments? Is it possible to learn what these return expectations are by segment? Based on the foregoing, should we be using public return data to derive private cost of capital?

3. Are Appraisers Comfortable Using Public Data? Source: Pepperdine Private Capital Markets Project Survey Report, Summer 2010.

4. Could this have anything to do with it? Public Roughly 6,500 companies listed on NYSE & NASDAQ 17,047 (0.10%) 5,868,737 (23.1%) 19,523,741 (76.8%) Source: U.S. Census Estimates, 2004. www.census.gov

5. Capital Market Lines 50% 40% 30% 20% 10% 0% Small Expected Returns Middle Large Debt Mezzanine Equity Source: Private Capital Markets, 2004, Robert T. Slee

6. Are public and private markets substitutes? Source: Private Capital Markets, 2004, Robert T. Slee

7. Capital Markets are Segmented by Return expectations Capital access and costs Market mechanisms and institutions Behavior of players Different capital market theories required? Robert T. Slee and Richard M. Trottier, “Capital Market Segmentation Matters,” Business Appraisal Practice, Summer 2006.

8. Sales ($millions) 5 150 500 1,000 Small Lower Middle Upper Large Businesses M id d l e M a r k e t Companies Different Theories for Different Segments Small Company Markets Theory Private Capital Markets Theory Corporate Finance Theory Source: Private Capital Markets, 2004, Robert T. Slee

10. What is Cost of Capital? Cost of capital is the expected rate of return that the market requires in order to attract funds to a particular investment The market refers to the universe of investors who are reasonable candidates to provide funds to a particular investment Thus, the relevant market of investors is the market that determines cost of capital Discount rates emanate from the return expectations of the capital providers Do the Build-Up Models pass this test?

11. Let’s Explore this Further So why are we not using private cost of capital data to value privately-held companies?

12. Pepperdine Private Capital Markets Project Surveys Semi-annual survey of private market participants launched in 2009 Web-based survey that included banks, asset based lenders, factors, mezzanine funds, private equity, venture capital, angel investors, business appraisers, investment bankers, business brokers, limited partners, and privately-held companies Typical survey asked about firm profile, behavior, credit box, historical returns, expected returns, view of next 12 months Capital providers were last surveyed in September 2010, results to be released later this month at http://bschool.pepperdine.edu/privatecapital Nearly 2,000 responses

15. Cost of Capital (gross annualized rates)

16. Cost of Capital Data (gross annualized rates %)

17. Banks (Senior Lenders) Refinancing accounted for 37.9% of loans; 15.5% financing growth Spreads 1.5% to 4% for 5-year fixed rate (over Prime) Nearly ¾ of cash flow based loan applications declined. Quality of cash flow, quality of earnings cited as primary reasons

18. Banks (Continued) Senior Leverage Multiples by Industry and EBITDA

19. Banks (Continued) Minimum Standards for Loan Approval

20. Banks (Continued) Pricing by Size and Type

21. Asset Based Lenders 37.1% get loans for refinancing followed by 18.6% for working capital fluctuations and just 17.1% for financing growth All in rates for working capital range from 4.6% to 18%. Decline 65-75% of loans. Insufficient collateral cited for 30% of denials followed by quality of earnings (15.8%) and cash flow (14.7%).

22. ABLs (Continued) Advance Rates

23. ABLs (Continued) All-in-Rates

24. Mezzanine Current funds exits so far yielding 20.5% gross IRR; Looking to earn 19% on new investments Takes 83 business plans to close one deal Refinancing accounted for 27.3%, growth at 19.1% Total debt to EBITDA and fixed charge coverage ratios most important lending characteristics Cash interest rates of 12-13% plus 2-3% PIK. Expect 2-10% from warrants Total EBITDA leverage ratios of 2.5X – 4.5X Holding periods from 4-5 years Looking to invest in service (33.3%) and manufacturing (27.8%) in next 12 months

25. Mezzanine (Continued)

26. Private Equity Early fund exits have returned 30% Review 100 business plans to close one deal Eyeing service (23.1%) and manufacturing (25.5%) firms over next 12 months

27. Private Equity (Continued) Expected Returns by Size Percent of Equity Purchased in Deals

28. Private Equity Deal Multiples

29. Buildup versus PCOC Survey Data

30. Buildup versus PCOC Survey Data

31. Buildup versus PCOC Survey Data

32. Buildup versus PCOC Survey Data

33. The PCOC Model is a discount rate based on pretax return expectations of private capital providers generates an illiquid, nonmarketable value Is stated mainly on a control basis – because PEGs and VCs use shareholder protections to control the investee even if they are a minority investor should eliminate the need for control premiums, as appraisers may just adjust the cash flow stream requires an adjustment for specific capital type risk (which replaces the specific company risk premium) should (all things being equal) derive higher values than Build-up models because of lower costs of capital

34. The Private Cost of Capital Model N is the number of sources of capital MVi is the market value of all outstanding securities i CAPi equals the median expected return for capital type i SCAPi equals the specific CAP risk adjustment for capital type i

35. Steps in Using PCOC To determine the appropriate CAPs by which to compare, review the credit boxes described in the most current Pepperdine survey. Select the appropriate median CAPe from the survey results. Apply a specific CAP risk adjustment (SCAPi) to the selected median CAPi based on a comparison of subject results to the appropriate survey credit box. Use upper and lower quartile returns as a guide to this adjustment. Determine the market value of each CAP. Then derive the percentage of capital structure for each CAP. Add the individual percentages from Step #4 to derive PCOC.

40. Impact of Using Private Discount Rate Data Using private capital market risk will move much of BVAL toward market relevancy Do we need DLOM? Do we need control premiums? How will minority interest discounts be calculated going forward? We can finally educate - then help - business owners/managers measure and create economic value

41. Where Do We Go From Here? Main PCOC article appeared in the March, 2010 Value Examiner. A “guidance” article will appear in a few months. Second edition of Private Capital Markets by Slee will cover the argument Training classes via webcasts presented by Slee/Paglia Next PCOC survey in Spring 2011 Expand surveys internationally Launch Center for Private Capital Markets The effort to make BVAL relevant to business will continue

42. Thank You! John K. Paglia Associate Professor of Finance Senior Researcher, Pepperdine Private Capital Markets Project Bschool.pepperdine.edu/privatecapital John.paglia@pepperdine.edu