The document discusses the private capital markets, highlighting the distinction between public and private markets, particularly focusing on middle market finance and value creation. It explores the challenges and characteristics of private equity, the concept of value gaps, and the complexities of business transfers, as well as various capital market theories. Additionally, it addresses expected versus realized returns for different types of capital, and the inefficiencies in private capital intermediation.

1. Private
Capital Markets
Presented by
Rob Slee, CM&AA, MA, MBA
© 2015 Robert T. Slee. All Rights Reserved. 1

2. Private Capital MarketsSlee
 Today’s Talk:
I. Public versus private markets
II. Middle Market Finance
III. Everything you need to know about value
creation
IV. Everything you need to know about M&A
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3. Private Capital MarketsSlee
 What are the Private Capital Markets?
• The venues where private capital is raised and
private equity interests are exchanged
The world’s biggest markets?
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4. Private Capital MarketsSlee
 Capital Markets Overview
4
Sales
($millions)
5 150 500 1,000
Small Lower Middle Upper Large
Businesses M I d d l e M a r k e t Companies
2-3x 4-7x 8-9x 10-11x >12x
5.4MM 300,000 2,000
15% 40% 45%

5. Private Capital MarketsSlee
 The Middle Market – What’s Happening?
• The US middle market is one of the largest economies in
the world
• There are 5,000-8,000 Private equity groups (PEGs) in
the US – with $1-2 trillion dollars in spending power
• PEGs own around 35,000 middle market companies
(12%) – but this represents about 30% of the market
equity…moving to more than 40% of equity by 2014
• Family Offices and Hedge Funds are newer to private
investments – but they have far more than $1 trillion
• Realized returns are dropping like a rock
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6. Private Capital MarketsSlee
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 Intermediated Value Gap
Middle Market Investments
Expected versus Realized Returns*
Investments Expected
Returns
Realized
Returns**
5 Year 10 Year 20 Year
Venture capital 38% 4.6% -1.5% 17.8%
Mezzanine capital 21% 2.7% 2.3% 6.7%
Private equity 25-30% 5.8% 2.8% 11.3%
*Thomson Reuters US Private Equity Performance Index (PEPI)
**Realized returns are net to investors after management fees and carried interest.

7. Private Capital MarketsSlee
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 Owner Value Gap
• Most lower middle market companies have a cost of
equity capital of 20-30%
• Yet 70-80% of owners do not generate returns on equity
to cover this cost of capital
• This means that over time, a value gap occurs (the
difference between what the owner wants/needs the
value to be…versus what the market says it is worth)
• The value gap shows-up in a number of negative ways
(lack of job creation; diminished GDP; lower loan
demand, etc.)

8. Private Capital MarketsSlee
 Finance: What is Currently Taught
• There is one primary capital market in the U.S.
• Corporate finance theory explains behavior of the
players
• Every business has one true value
• Capital is efficiently allocated and priced
• Going public is the primary goal of a business
owner
• What’s the problem?
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9. Private Capital MarketsSlee
 Upon Further Review
• Capital markets are segmented in the U.S.
• Various finance theories explain behavior of the
players
• Every business has dozens of correct values at
any point in time
• Private capital is not efficiently allocated and
priced
• More companies will go private than public for the
foreseeable future
• A new belief system developing?
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10. Private Capital MarketsSlee
 Public and Private Capital Markets are Not
Substitutes
• Risk/return is different
• Liquidity is different
• Management involvement is different
Robert T. Slee, “Public and Private Capital Markets are Not Substitutes,” Business
Appraisal Practice, Spring 2005.
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11. Private Capital MarketsSlee
 A Tale of Two Markets
Public Markets (Wall St.) Private Markets (Main St.)
Use of a C corporation Can be any type entity (S, LLC, etc)
Value is established by a market Value is established at a point in time
Ready access to public capital markets No access to public capital markets
Owners have limited liability Owners have unlimited liability
Owners are well diversified Owners have one primary asset
Professional management Owner management
Company has infinite life Typical company life of one generation
Liquid securities efficiently traded Illiquid securities inefficiently traded
Profit maximization as goal Personal wealth creation as goal
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12. Private Capital MarketsSlee
 Capital Market Theories
• Useful capital market theories explain, organize
and predict behavior of players in a capital market
• Theory doesn’t always meet practice
• Do corporate finance theories predict behavior in
private capital markets?
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13. Private Capital MarketsSlee
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Meta-Financial Theories
- Risk & Return
- Rational Man/Market
- Utility Theory
- General Equilibrium Theory
- Decision & Game Theory
Small Company
Markets Theory
Corporate
Finance Theory
Middle Market
Finance Theory

14. Private Capital MarketsSlee
 Different Theories for Different Segments
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Sales
($millions)
5 150 500 1,000
Small Lower Middle Upper Large
Businesses M I d d l e M a r k e t Companies
Small Company
Markets Theory
Middle Market Finance Theory
Corporate Finance Theory

15. Private Capital MarketsSlee
 Capital Market Lines
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50%
40%
30%
20%
10%
0%
ExpectedReturns
Small
Middle
Large
Debt Mezzanine Equity

16. Private Capital MarketsSlee
 Middle Market Finance
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Middle
Market
Finance
Theory
Valuation
TransferCapital
T
R
I
A
N
G
U
L
A
T
I
O
N

17. Private Capital MarketsSlee
II. Middle Market Finance
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18. Private Capital MarketsSlee
 Middle Market Finance
• The study of how managers of private middle market
companies make investment and financing decisions
• Value Relativity: Value is relative to the reason for an
appraisal
• The Bizarre Bazaar: Private capital is allocated in a
bazaar
• Transfer Spectrum: Business transfer comprises a
spectrum of alternatives
• You are lost until you understand the integrated
structure of private finance
(story time…)
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19. Private Capital MarketsSlee
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20. Private Capital MarketsSlee
 Professional ‘Value’ Today
• Historic and forensic
• Compliance-oriented
• Notional
• Measured with singular certainty
But not the least bit useful in making investment
and financing decisions
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21. Private Capital MarketsSlee
 Value World Theory
• Motive leads to a reason for an appraisal
• The reason for an appraisal selects a value world
• A private business value is relative to the value world
in which it is viewed
• Therefore every private company has dozens of
correct values at one point in time
• Why is there value relativity? Because I say so…
NOT!
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22. Private Capital MarketsSlee
 A Few Value Worlds
• Market Value – what the open market says the
business is worth (Asset, Financial, and Synergy
Subworlds)
• Fair Market Value – what the IRS/Courts say it is worth
• Owner Value – what the owner says it is worth
• Investor Value – what an investor says it is worth
• Collateral Value – what the bank says it is worth
• Incremental Business Value – returns greater than
investment
• Others: Insurable; Early Equity; Public; Fair Value
• The 30 second rule
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23. Private Capital MarketsSlee
 What is Different in Each Value World?
• One or more Authorities dictate a unique valuation
process used in a value world
• In the case of competing Authorities, the one with the
more compelling argument usually wins
• The benefit stream is different by world (return)
• The return expectation is different by world (risk)
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24. Private Capital MarketsSlee
 Market Value
• The highest price available in the marketplace for
the assets or stock of the company
• These are open market values (you might refer to
them as a group of investment values)
• 3 subworlds: Asset, Financial and Synergy
• Brokers and asset appraisers are the Authorities
• Most owners don’t want to transfer in the Asset
subworld (although…)
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25. Private Capital MarketsSlee
 Asset Market Value
• The Subworld without operating goodwill
• If the subject should be viewed in this subworld,
determine the net asset value
• It’s a judgment call regarding using liquidation
values, fair market values, or market values of
assets
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26. Private Capital MarketsSlee
 Stream versus Multiple
• Financial and Synergy market value:
 Equals the “Stream times the Multiple”
(EBITDA times an acquisition multiple)
 The Stream is influenced by the presenter
 The Buyer brings the multiple
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27. Private Capital MarketsSlee
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 It’s a Recast World
• Which earnings level do you use to value?
 Reported EBITDA $1MM
 Recast EBITDA $2MM
 Synergized recast EBITDA $3MM
Using a ‘5’ multiple, the same company has a $5MM, $10MM, and
$15MM market value – depending on which earnings level is used

28. Private Capital MarketsSlee
 Financial Market Value
Subject Profile: Positive earning capacity
Investor Profile: Individual/Nonstrategic
Process: Recast EBITDA times a multiple
Seller keeps Cash + RE + LTD; Buyer takes Operating
assets plus assumes Current liabilities
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29. Private Capital MarketsSlee
 Synergy Market Value
Subject Profile: Positive earning capacity plus a
cherished market position
Investor Profile: Synergistic
Process: Synergistic recast EBITDA
times a multiple
Only “hard” synergies need apply (PCMs – p. 98)
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30. Private Capital MarketsSlee
 Market Value - Conclusion
• Most private owners want to increase the value of
their company in this world
• Risk – acquisition multiple is specific to a buyer and
reflects their risk assessment (hurdle rate)
• Return – EBITDA available post-transaction
• Big opportunity for us to help owners plan and
execute
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31. Private Capital MarketsSlee
 Fair Market Value
• Most IRS/Tax Courts/ERISA laws… are the
Authorities in this world
• Are we trying to do too much in this world?
• Will FMV ever mirror the reality of the market?
• Private Cost of Capital Model (PCOC)
• Can PCOC be used across value worlds?
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32. Private Capital MarketsSlee
 The Bizarre Bazaar of Private Capital
• Why a bazaar and not a supermarket?
• There is a structure and rules
• Be prepared for financial hand-to-hand combat
• Realize that capital providers constantly move their
tents
• Need to create capital solutions one deal at a time
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33. Private Capital MarketsSlee
 Structure of the Bazaar
• Private capital owner motives include a desire: for few
shareholders; to stretch equity; to eliminate personal
guarantees; to manage business – not balance sheet
• Capital is allocated based on the credit requirements of
the providers (credit box)
• Capital providers have unique return expectations
• Return expectations are all-in rates (not just stated
interest rates)
• Let’s review this structure in more depth
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34. Private Capital MarketsSlee
 Mezzanine - Capital Coordinates
34
Definition Subordinated debt that relies on cash interest, payment in
kind (PIK), plus warrants for its return
Required Rate of Return 19.5% (pretax median return expectation - $10MM)
Likely Provider SBICs, private funds
Value World (s) Market value
Transfer Method (s) Private and Public Auction
Appropriate to Use When… The subject is experiencing high growth but has little free
liquidity. Mezzanine is often the next type of capital to add
to the capital structure if senior lending becomes restricted
because mezzanine is less expensive than equity.
Key Points to Consider Beyond the 11-12% current coupon interest rate, a
provider will structure a fairly heavy warrant position. The
longer this warrants goes unexercised, the more costly it
becomes to the investee.
Performance ratchets may be used to incentivize
management to reach performance targets.

35. Private Capital MarketsSlee
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 Mezzanine – Credit Box
To Qualify for Mezzanine Capital, an Applicant Must:
• Have terrific growth prospects, at least 20% compounded per year
• Have a management team experienced in high-growth situations
• Have sufficient cash flow beginning in year 2 to enable payment of
principal and interest
• Have total debt to EBITDA no more than 3.5
• Employ a capital structure that puts the mezzanine in no worse than a
second lien position
• Possess a scalable business model
• Have some equity support

36. Private Capital MarketsSlee
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 Mezzanine – Sample Terms
Example Loan: $7 million loan
Interest Rate: 12% fixed, payable monthly
PIK interest = 2%
Term: Interest only for 12 months
Monthly principal + interest on 10
year amortization, with all principal
due in 5 years
Detachable Warrants: 5% of the fully diluted common
Commitment Fee: 1% of loan
Closing Fee: 2% of facility amount

37. Private Capital MarketsSlee
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 Mezzanine - Expected Returns
1. Total Interest Cost
($7 million loan times 14% interest rate) $980,000
2. Warrant Cost
($1.73 million spread over 5 years) 346,000
3. Commitment Fee
($7 million Loan Amount times 1% divided by 5
years)
14,000
4. Closing Fee
($7 million Loan Amount times 2% divided by 5
years)
28,000
Annual Returns of Loan $1,368,000
Expected Rate of Return
($1,368,000/$7,000,000)
19.5%

38. Private Capital MarketsSlee
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39. Private Capital MarketsSlee
Pepperdine Private Capital Market Line
Lower Middle Market Expected Returns ($5-10M)
41.8%
37.5%
30.0%
21.0%
8.0%
5.0%
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
Banks ABL Mezzanine Private
Equity
Venture
Capital
Factoring
Capital Types
ExpectedReturns(%)
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40. Private Capital MarketsSlee
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 Key Capital Issues
• The Pepperdine Private Capital Market Line and surveys
have enabled Slee/Paglia to create the Private Cost of
Capital Model
• Private cost of capital is 3-4 times higher than public cost
of capital…relatively little private value is being created
• Intermediation in the private capital markets is inefficient
• Credit boxes enable capital access and the ability to
reduce cost of capital
• Most owners do not have a value creation framework

41. Private Capital MarketsSlee
 Business Transfer
• Business transfer reflects all possible ways or methods
to transfer or exchange a private business interest
• An owner’s transfer motive selects a transfer channel
(e.g., Employee channel)
• Each channel contains numerous transfer methods
(e.g., ESOP or MBO)
• Transfer methods select value worlds!
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42. Private Capital MarketsSlee
 Business Transfer Spectrum
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Employees Family Co-Owners
Outside
[Retire]
Outside
[Continue] Public
Charitable
Trusts
T R A N S F E R M O T I V E S
T R A N S F E R M E T H O D S
ESOPs
Management
Buyouts/Ins
Phantom
Stock
Stock Appre-
ciation Rights
Charitable
Remainder
Trusts
Charitable
Lead Trusts
Outright
Gifts
SCINs
Annuities
GRATs
FLPs
IDGTs
Negotiated
One-Step
Private
Auctions
Two-Step
Private
Auctions
Consolidate
Roll-ups
Buy and
Build
Recapitali-
zations
Initial Public
Offerings
Direct Public
Offerings
Reverse
Mergers
Going
Private
INTERNAL
TRANSFERS
EXTERNAL
TRANSFERS
Buy/Sell
Russian
Roulette
Dutch
Auction
Right of
First
Refusal
T R A N S F E R C H A N N E L S

43. Private Capital MarketsSlee
PERSONAL BUSINESS MARKET
 Do Most Owners Want to Create Entity Value?
• No – it’s about lifestyle for most. What’s wrong with this?
• What are the three most important things in real estate
valuation? In business valuation?
• Let’s play the transfer timing slots game

44. Private Capital MarketsSlee
 Private Market Timing
 How to play this cycle?
U.S. Ten Year Transfer Cycle
Deal Recession Prime Selling Time Uncertainty
(Buyer’s Market) (Seller’s Market) (Neutral Market)
1980 1983 1988 1990
1990 1993 1998 2000
2000 2003 2008 2010
2011 2013 2018 2020

45. Private Capital MarketsSlee
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 Owner Motives Matter – PrivateCo’s Values
Business Owners Choose a Transfer Value!
Method Value World Value
Buy/Sell Asset Market Value $ 2.4 MM
MBO Investment Value 7.5 MM
ESOP Fair Market Value 9.2 MM
Equity Recap Financial Market Value 12.0 MM
Negotiated Owner Value 15.8 MM
Auction Synergy Market Value 16.6 MM
Public Public Value 18.2 MM

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III. Everything You Need to Know About Value
Creation

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 Everything You Need To Know About Value
Creation
• We all choose our level of value/wealth based on how
we spend our time
• The idea of personal hourly hurdle rates
• Slee’s Law of value creation
• cLadder versus vLadder

48. Private Capital MarketsSlee
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 The vLadder

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IV. Everything You Need to Know About M&A

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 Paradoxes Shape M&A
• M&A is more of a SPORT than a BUSINESS
• Companies that NEED help the most are the least
WILLING to pay for it
• A deal only STARTS once it has DIED
• The LARGER the deal, the EASIER it is to close
• The MORE you care about a deal the LESS likely it is
to close
• The best referral SOURCES also have the MOST to
lose by making the referral
• We can do EVERYTHING right yet still come up
EMPTY!

51. Private Capital MarketsSlee
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 Food for Thought
• Given globalization, what should
intermediaries, owners and managers be doing
now?
• How is globalization changing the middle
market?
• How can we use Middle Market Finance to
create substantial value?
• Final thing I want you to do