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Private
Capital Markets
Presented by
Rob Slee, CM&AA, MA, MBA
© 2015 Robert T. Slee. All Rights Reserved. 1
Private Capital MarketsSlee
 Today’s Talk:
I. Public versus private markets
II. Middle Market Finance
III. Everything you...
Private Capital MarketsSlee
 What are the Private Capital Markets?
• The venues where private capital is raised and
priva...
Private Capital MarketsSlee
 Capital Markets Overview
4
Sales
($millions)
5 150 500 1,000
Small Lower Middle Upper Large
...
Private Capital MarketsSlee
 The Middle Market – What’s Happening?
• The US middle market is one of the largest economies...
Private Capital MarketsSlee
6
 Intermediated Value Gap
Middle Market Investments
Expected versus Realized Returns*
Invest...
Private Capital MarketsSlee
7
 Owner Value Gap
• Most lower middle market companies have a cost of
equity capital of 20-3...
Private Capital MarketsSlee
 Finance: What is Currently Taught
• There is one primary capital market in the U.S.
• Corpor...
Private Capital MarketsSlee
 Upon Further Review
• Capital markets are segmented in the U.S.
• Various finance theories e...
Private Capital MarketsSlee
 Public and Private Capital Markets are Not
Substitutes
• Risk/return is different
• Liquidit...
Private Capital MarketsSlee
 A Tale of Two Markets
Public Markets (Wall St.) Private Markets (Main St.)
Use of a C corpor...
Private Capital MarketsSlee
 Capital Market Theories
• Useful capital market theories explain, organize
and predict behav...
Private Capital MarketsSlee
13
Meta-Financial Theories
- Risk & Return
- Rational Man/Market
- Utility Theory
- General Eq...
Private Capital MarketsSlee
 Different Theories for Different Segments
14
Sales
($millions)
5 150 500 1,000
Small Lower M...
Private Capital MarketsSlee
 Capital Market Lines
15
50%
40%
30%
20%
10%
0%
ExpectedReturns
Small
Middle
Large
Debt Mezza...
Private Capital MarketsSlee
 Middle Market Finance
16
Middle
Market
Finance
Theory
Valuation
TransferCapital
T
R
I
A
N
G
...
Private Capital MarketsSlee
II. Middle Market Finance
17
Private Capital MarketsSlee
 Middle Market Finance
• The study of how managers of private middle market
companies make in...
Private Capital MarketsSlee
19
Private Capital MarketsSlee
 Professional ‘Value’ Today
• Historic and forensic
• Compliance-oriented
• Notional
• Measur...
Private Capital MarketsSlee
 Value World Theory
• Motive leads to a reason for an appraisal
• The reason for an appraisal...
Private Capital MarketsSlee
 A Few Value Worlds
• Market Value – what the open market says the
business is worth (Asset, ...
Private Capital MarketsSlee
 What is Different in Each Value World?
• One or more Authorities dictate a unique valuation
...
Private Capital MarketsSlee
 Market Value
• The highest price available in the marketplace for
the assets or stock of the...
Private Capital MarketsSlee
 Asset Market Value
• The Subworld without operating goodwill
• If the subject should be view...
Private Capital MarketsSlee
 Stream versus Multiple
• Financial and Synergy market value:
 Equals the “Stream times the ...
Private Capital MarketsSlee
27
 It’s a Recast World
• Which earnings level do you use to value?
 Reported EBITDA $1MM
 ...
Private Capital MarketsSlee
 Financial Market Value
Subject Profile: Positive earning capacity
Investor Profile: Individu...
Private Capital MarketsSlee
 Synergy Market Value
Subject Profile: Positive earning capacity plus a
cherished market posi...
Private Capital MarketsSlee
 Market Value - Conclusion
• Most private owners want to increase the value of
their company ...
Private Capital MarketsSlee
 Fair Market Value
• Most IRS/Tax Courts/ERISA laws… are the
Authorities in this world
• Are ...
Private Capital MarketsSlee
 The Bizarre Bazaar of Private Capital
• Why a bazaar and not a supermarket?
• There is a str...
Private Capital MarketsSlee
 Structure of the Bazaar
• Private capital owner motives include a desire: for few
shareholde...
Private Capital MarketsSlee
 Mezzanine - Capital Coordinates
34
Definition Subordinated debt that relies on cash interest...
Private Capital MarketsSlee
35
 Mezzanine – Credit Box
To Qualify for Mezzanine Capital, an Applicant Must:
• Have terrif...
Private Capital MarketsSlee
36
 Mezzanine – Sample Terms
Example Loan: $7 million loan
Interest Rate: 12% fixed, payable ...
Private Capital MarketsSlee
37
 Mezzanine - Expected Returns
1. Total Interest Cost
($7 million loan times 14% interest r...
Private Capital MarketsSlee
38
Private Capital MarketsSlee
Pepperdine Private Capital Market Line
Lower Middle Market Expected Returns ($5-10M)
41.8%
37....
Private Capital MarketsSlee
40
 Key Capital Issues
• The Pepperdine Private Capital Market Line and surveys
have enabled ...
Private Capital MarketsSlee
 Business Transfer
• Business transfer reflects all possible ways or methods
to transfer or e...
Private Capital MarketsSlee
 Business Transfer Spectrum
42
Employees Family Co-Owners
Outside
[Retire]
Outside
[Continue]...
Private Capital MarketsSlee
PERSONAL BUSINESS MARKET
 Do Most Owners Want to Create Entity Value?
• No – it’s about lifes...
Private Capital MarketsSlee
 Private Market Timing
 How to play this cycle?
U.S. Ten Year Transfer Cycle
Deal Recession ...
Private Capital MarketsSlee
45
 Owner Motives Matter – PrivateCo’s Values
Business Owners Choose a Transfer Value!
Method...
Private Capital MarketsSlee
46
III. Everything You Need to Know About Value
Creation
Private Capital MarketsSlee
47
 Everything You Need To Know About Value
Creation
• We all choose our level of value/wealt...
Private Capital MarketsSlee
48
 The vLadder
Private Capital MarketsSlee
49
IV. Everything You Need to Know About M&A
Private Capital MarketsSlee
50
 Paradoxes Shape M&A
• M&A is more of a SPORT than a BUSINESS
• Companies that NEED help t...
Private Capital MarketsSlee
51
 Food for Thought
• Given globalization, what should
intermediaries, owners and managers b...
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Private Capital Markets

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Public versus private markets.
Middle market finance.
Everything you need to know about value creation.
Everything you need to know about M&A.

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Private Capital Markets

  1. 1. Private Capital Markets Presented by Rob Slee, CM&AA, MA, MBA © 2015 Robert T. Slee. All Rights Reserved. 1
  2. 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 2
  3. 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? 3
  4. 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. 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 5
  6. 6. Private Capital MarketsSlee 6  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. 7. Private Capital MarketsSlee 7  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. 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? 8
  9. 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? 9
  10. 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. 10
  11. 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 11
  12. 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? 12
  13. 13. Private Capital MarketsSlee 13 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. 14. Private Capital MarketsSlee  Different Theories for Different Segments 14 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. 15. Private Capital MarketsSlee  Capital Market Lines 15 50% 40% 30% 20% 10% 0% ExpectedReturns Small Middle Large Debt Mezzanine Equity
  16. 16. Private Capital MarketsSlee  Middle Market Finance 16 Middle Market Finance Theory Valuation TransferCapital T R I A N G U L A T I O N
  17. 17. Private Capital MarketsSlee II. Middle Market Finance 17
  18. 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…) 18
  19. 19. Private Capital MarketsSlee 19
  20. 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 20
  21. 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! 21
  22. 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 22
  23. 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) 23
  24. 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…) 24
  25. 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 25
  26. 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 26
  27. 27. Private Capital MarketsSlee 27  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. 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 28
  29. 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) 29
  30. 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 30
  31. 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? 31
  32. 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 32
  33. 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 33
  34. 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. 35. Private Capital MarketsSlee 35  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. 36. Private Capital MarketsSlee 36  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. 37. Private Capital MarketsSlee 37  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. 38. Private Capital MarketsSlee 38
  39. 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(%) 39
  40. 40. Private Capital MarketsSlee 40  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. 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! 41
  42. 42. Private Capital MarketsSlee  Business Transfer Spectrum 42 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. 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. 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. 45. Private Capital MarketsSlee 45  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
  46. 46. Private Capital MarketsSlee 46 III. Everything You Need to Know About Value Creation
  47. 47. Private Capital MarketsSlee 47  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. 48. Private Capital MarketsSlee 48  The vLadder
  49. 49. Private Capital MarketsSlee 49 IV. Everything You Need to Know About M&A
  50. 50. Private Capital MarketsSlee 50  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. 51. Private Capital MarketsSlee 51  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

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