Pepperdine Private Cost of Capital 10.08.10

The Private Cost of Capital ModelIACVA Conference, October 8, 2010

John K. Paglia, Senior Researcher,Denney Academic Chair,

and Associate Professor of Finance

• 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?

Are Appraisers Comfortable Using Public Data?

Revenues Size

Very Uncomfortable

(-3)Uncomfortable

(-2)

Slightly Uncomfortable

(-1)Neutral

(0)

Slightly Comfortable

(1)Comfortable

(2)

Very Comfortable

(3) Average

< $1M 33.7% 22.9% 18.1% 8.4% 3.0% 7.8% 6.0% -1.3$1M -$5M 16.7% 28.0% 17.3% 17.3% 4.2% 9.5% 7.1% -0.8$5M -$25M 4.7% 18.3% 22.5% 15.4% 14.8% 16.0% 8.3% 0.0$25M -$100M 3.8% 2.5% 15.0% 19.4% 18.8% 25.0% 15.6% 0.8

$100M -$500M 2.9% 2.2% 3.6% 11.7% 13.1% 42.3% 24.1% 1.5

$500M - $1B 2.3% 2.3% 0.8% 4.7% 5.4% 37.2% 47.3% 2.1 > $1B 2.4% 2.4% 0.0% 5.6% 4.0% 23.4% 62.1% 2.3

Source: Pepperdine Private Capital Markets Project Survey Report, Summer 2010.

Could this have anything to do with it?

Source: U.S. Census Estimates, 2004. www.census.gov

>500 employee

s

Fewer than 500 employees

Non-employer companies

19,523,741 (76.8%)

5,868,737 (23.1%)

17,047 (0.10%)

PublicRoughly 6,500 companies listed on NYSE & NASDAQ

50%

40%

30%

20%

10%

0%

Expe

cted

Ret

urns

SmallMiddle

Large

Debt Mezzanine Equity

Capital Market Lines

Source: Private Capital Markets, 2004, Robert T. Slee

Are public and private markets substitutes? 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 may 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


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.

Different Theories for Different SegmentsSales($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

Private Capital Markets Theory

Corporate Finance Theory


Payback

Internal R

ate of R

eturn

(IRR)

Discounted

Cash Flo

w (DCF)

Multiple Analy

sis

Market

Analysis

Option Analysis

Decisio

n trees

Simulati

on Analysis

(i.e.,

Monte Carl

o meth

ods)

Scenari

o Analysis

Gut feel

0.0%10.0%20.0%30.0%40.0%50.0%60.0%70.0%80.0%90.0%

100.0%

76%

85%

49%

82%89%

15%21%

11%

66%

93%

How Are Investments Evaluated in the Private Markets?

Angel VC PE Mezz Business Average

Source: Pepperdine Private Capital Markets Project Survey Report, February 2010

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?

AttributePrivately-held Companies Buildup / CAPM

Private Cost of Capital Models More Relevant?

Ownership Mostly control Minority Control PCOC

Liquidity Illiquid Liquid Illiquid PCOC

Marketability Non-marketable Marketable Non-marketable PCOC

Taxes and cash flows

Focus on owner wealth

After-tax cash flows

Pre-tax cash flows PCOC

Access to capital Private markets Public markets Private markets PCOC

Let’s Explore this Further

So why are we not using private cost of capital data to value privately-held companies?

• 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

Pepperdine Private Capital Markets Project Surveys

1st quartile Median 3rd quartile

Bank (CF loan) $500K 5.8% 6.0% 6.5%$5M 5.0% 5.5% 7.5%

$10M 4.1% 5.5% 7.5%$25M 3.4% 5.0% 6.8%$50M 3.3% 3.5% 6.0%

$100M 3.2% 3.4% 4.3%ABL (loan) $500K 11.0% 18.0% 20.0%

$5M 4.3% 8.0% 12.0%$10M 3.3% 6.3% 7.3%$25M 3.3% 4.6% 6.5%

Mezz (EBITDA) $1M 20.8% 21.5% 22.5%$5M 18.0% 19.0% 21.0%

$10M 18.0% 19.0% 21.3%$25M 17.3% 18.0% 18.0%

PEG (EBITDA) $1M 27.3% 30.0% 31.8%$5M 25.0% 30.0% 30.0%

$10M 21.5% 25.0% 30.0%$25M 23.8% 25.0% 27.8%$50M 25.0% 25.0% 29.0%

$100M 17.5% 20.0% 22.5%

Cost of Capital (gross annualized rates)


VC Startup 35.0% 40.0% 50.0%Early stage 30.0% 36.0% 45.0%Expansion 26.3% 30.0% 34.3%Later stage 25.0% 25.0% 28.0%

Angel Seed 40.0% 60.0% 100.0%Startup 30.0% 45.0% 75.0%

Early stage 30.0% 35.0% 60.0%Expansion 22.5% 30.0% 40.0%Later stage 20.0% 30.0% 40.0%

Factor $100K/mo. 58.9% 74.5% 87.6%$250K/mo. 50.8% 62.8% 74.5%$500K/mo. 48.8% 59.8% 83.4%$1M/mo. 38.0% 52.0% 75.4%$5M/mo. 27.3% 39.0% 58.9%

Cost of Capital Data (gross annualized rates %)

• 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

Banks (Senior Lenders)

37.9%

8.3%15.5%1.5%

12.5%

0.7%

13.4%8.1% 2.1%

RefinancingManagement buy-outFinancing growthChapter 11 workoutAcquisition loanDebtor-in-possessionWorking capital fluctuationsEquipment or buildingOther

Senior Leverage Multiples by Industry and EBITDABanks (Continued)

$1M $5M $10M $25M $50M $100MService

1st quartile 1.5 1.5 2.0 2.0 2.4 2.4Median 1.5 2.0 2.5 2.5 3.0 3.03rd quartile 2.8 2.8 2.8 3.0 3.0 3.3

Manufacturing1st quartile 1.5 1.5 2.0 2.5 2.5 2.5Median 1.5 2.0 2.3 2.5 2.8 2.83rd quartile 3.0 3.0 2.8 3.0 3.0 3.0

Retail1st quartile 1.4 1.4 1.5 1.8 2.3 n.a.Median 1.5 1.7 2.0 2.0 2.5 n.a.3rd quartile 1.8 2.1 2.3 2.5 2.8 n.a.

Wholesale1st quartile 1.5 1.5 2.0 2.4 2.5 2.5Median 1.5 2.0 2.3 2.5 2.5 2.53rd quartile 3.0 3.0 2.8 2.8 2.9 2.9

Minimum Standards for Loan ApprovalBanks (Continued)


Current Ratio 1.0 1.0 1.2Fixed-charge coverage 1.1 1.2 1.4Senior debt service 1.2 1.4 1.7Total debt service ratio 1.2 1.3 1.4Senior debt to EBITDA 2.3 2.8 3.0Total debt to EBITDA 2.4 3.5 4.2Debt to net worth 1.9 2.5 3.3Debt to tangible net worth 2.0 2.5 3.0

Pricing by Size and TypeBanks (Continued)

Real estate

Working capital Equipment Cash flow

loan1st quartile $0.5M 6.0% 4.7% 5.7% 5.8%Median 6.0% 5.3% 6.0% 6.0%3rd quartile 6.6% 6.0% 6.6% 6.5% $5M

1st quartile 6.0% 3.3% 4.1% 5.0%Median 6.0% 4.3% 5.0% 5.5%3rd quartile 6.3% 5.0% 6.3% 7.5% $10M

1st quartile 6.0% 3.1% 3.5% 4.1%Median 6.0% 3.6% 4.8% 5.5%3rd quartile 6.3% 6.3% 7.0% 7.5% $25M

1st quartile 5.8% 2.5% 3.1% 3.4%Median 5.9% 3.0% 3.1% 5.0%3rd quartile 5.9% 3.3% 3.2% 6.8%

• 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%).

Asset Based Lenders

37.1%

2.8%

17.1%

4.5%

11.9%

1.1%

18.6%4.1%2.6%

Motivation for Securing Financining Refinancing

Management buy-out

Financing growth

Chapter 11 workout

Acquisition loan

Debtor in possession

Working capital fluctuations

Equipment or building

Other

Advance RatesABLs (Continued)

1st quartile Median 3rd quartileMarketable securities Typical 71.3% 80.0% 90.0%

Max 80.0% 90.0% 95.0%Accounts receivable Typical 80.0% 80.0% 85.0%

Max 85.0% 85.0% 90.0%Inventory - low quality Typical 20.0% 25.0% 37.5%

Max 25.0% 30.0% 40.0%Inventory - intermediate quality Typical 25.0% 40.0% 50.0%

Max 42.5% 50.0% 50.0%Inventory - high quality Typical 50.0% 52.5% 60.0%

Max 55.0% 65.0% 67.5%Equipment Typical 50.0% 70.0% 85.0%

Max 70.0% 80.0% 85.0%Real estate Typical 50.0% 57.5% 70.0%

Max 65.0% 70.0% 75.0%Land assets Typical 20.0% 40.0% 65.0%

Max 50.0% 62.5% 75.0%

All-in-RatesABLs (Continued)

1st quartile Median 3rd quartileReal estate all-in-rate (%)

$0.5M 10.1% 12.0% 16.0%$5M 7.5% 10.0% 14.8%$10M 4.9% 9.0% 12.8%$25M 6.3% 7.0% 12.8%

Working capital all-in-rate (%)$0.5M 11.0% 18.0% 20.0%$5M 4.3% 8.0% 12.0%$10M 3.3% 6.3% 7.3%$25M 3.3% 4.6% 6.5%

Equipment all-in-rate (%)$0.5M 12.0% 18.0% 20.0%$5M 9.5% 15.0% 19.5%$10M 3.4% 8.0% 15.0%$25M 4.9% 7.1% 9.0%

• 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

Mezzanine

27.3%

23.1%19.1%0.5%

19.8%

0.5%

6.7% 3.0%

Motivation for Investment Refinancing

Management buy-out

Financing growth

Chapter 11 workout

Acquisition loan

Debtor-in-possession

Dividend recap

Other

33.3%

27.8%2.2%

1.2%

8.3%1.3%

0.3%

0.2% 12.8%

0.8%

9.4% 1.2% 1.1%

Industry Investments Over Next 12 Months

ServiceManufacturingRetailWholesaleDistributionOil & GasRestaurantReal EstateHealthcareFinance and relatedTechnologyMedia and Enter-tainmentClean technologyLife sciencesOther

Mezzanine (Continued)$1M $5M $10M $25M $50M

Total interest rate (%)1st quartile 12.0% 12.6% 15.1% 13.0% 15.0%Median 14.0% 14.0% 16.0% 14.5% 15.0%3rd quartile 14.0% 15.8% 16.0% 15.0% 15.0%

% of deals with warrants1st quartile 90.0% 80.0% 50.0% 5.0% 10.0%Median 100.0% 90.0% 80.0% 25.0% 10.0%3rd quartile 100.0% 100.0% 100.0% 80.0% 10.0%

Warrant coverage

1st quartile 10.0% 5.0% 5.0% 4.3% n.a.Median 15.0% 8.0% 5.0% 5.0% n.a.3rd quartile 20.0% 10.0% 5.0% 5.3% n.a.

Expected return from warrants (%)

1st quartile 6.0% 5.0% 3.0% 1.8% n.a.Median 9.0% 8.0% 4.0% 2.5% n.a.3rd quartile 10.0% 10.0% 10.0% 4.8% n.a.

• 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

Private Equity

23.1%

25.5%

1.5%1.4%7.5%7.2%0.6%

2.9%8.0%

5.8%5.1%

2.4%0.8%

2.7%

5.3%

Investments Over Next 12 Months ServiceManufacturingRetailWholesaleDistributionOil & GasRestaurantReal EstateHealthcareFinance and relatedTechnologyMedia and EntertainmentClean technologyLife sciencesOther

Private Equity (Continued)Total expected returns (gross cash on cash pretax IRR) on new investments (%) $1M $5M $10M $25M $50M $100M

1st quartile 27% 25% 21% 23% 25% 17%Median 30% 30% 25% 25% 25% 20%3rd quartile 31% 30% 30% 27% 29% 22%

$5M $10M $25M $50M $100M1st

quartile 60.0% 72.5% 65.0% 47.5% 51.3%

Median 80.0% 80.0% 70.0% 67.5% 62.5%3rd

quartile 95.0% 92.5% 85.0% 88.8% 73.8%

Percent of Equity Purchased in Deals

Expected Returns by Size

Private Equity Deal Multiples$1M

EBITDA$5M

EBITDA$10M

EBITDA$25M

EBITDA$50M

EBITDA$100M EBITDA

Service1st quartile 3.6 5 5.3 5.5 6.5 6.5Median 4 5 6 7 9 93rd quartile 4 5.6 6.8 8 9 9.5

Manufacturing1st quartile 3.5 5 5 6 6.5 6.8Median 4 5 6 6 7 7.53rd quartile 4 5 6 7 7.5 8.3

Retail1st quartile 3 4 4.8 5.5 7.5 n.a.Median 4 4.5 5.5 7 8 n.a.3rd quartile 4 5 6.3 8 8.5 n.a.

Distribution1st quartile 3 4.3 5 5 4.5 4.5Median 3.8 5 5 5 6 63rd quartile 4 6 6.1 6.5 7.5 7.5

Buildup versus PCOC Survey DataManufacturing Company

Cost of equity capital comparison: Buildup vs. PCOC by Size

$1M $25M $250MRisk-free (survey) 4.0% 4.0% 4.0%Equity risk premium (survey) 6.2% 6.2% 6.2%Industry Adjustment (survey) 2.0% 2.0% 2.0%Size Premium (survey) 6.8% 5.8% 4.0%Company Specific (survey) 5.0% 3.8% 2.3%Buildup Equity rate (After tax) 24.0% 21.8% 18.5%



$1M $25M $250MRisk-free (survey) 4.0% 4.0% 4.0%Equity risk premium (survey) 6.2% 6.2% 6.2%Industry Adjustment (survey) 2.0% 2.0% 2.0%Size Premium (survey) 6.8% 5.8% 4.0%Company Specific (survey) 5.0% 3.8% 2.3%Buildup Equity rate (After tax) 24.0% 21.8% 18.5%Buildup Equity rate (Pre tax @ 30%) 34.3% 31.1% 26.4%




DLOM (survey) 30.4% 27.6% 21.8%Buildup Equity rate (Pre-tax, DLOM adjusted) 49% 43% 34%




DLOM (survey) 30.4% 27.6% 21.8%Buildup Equity rate (Pre-tax, DLOM adjusted) 49% 43% 34%PCOC (Pre-tax as reported) 30% 30% 25%Difference 19% 13% 9%

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

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

N

j j

iii

N

i MVMVSCAPCAPPCOC

11

)(

Steps in Using PCOC1. To determine the appropriate CAPs by which to compare,

review the credit boxes described in the most current Pepperdine survey.

2. Select the appropriate median CAPe from the survey results.

3. 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.

4. Determine the market value of each CAP. Then derive the percentage of capital structure for each CAP.

5. Add the individual percentages from Step #4 to derive PCOC.

Middle Market Manufacturing, Inc.As of September 30, 2010

(Market Value Balance Sheet)

Assets $M Liabilities and Equity $MInvest. Size

Cost of capital

Net working capital $0.0

Long-lived assets $25.0

Total Assets $25.0 Total Liabilities & Equity $25.0

EBITDA $5 Multiple 5xMarket Value $25M




Cost of capital


Long-lived assets $25.0 Senior Debt $7.5 1.5xSubordinated Debt $5.0 1.0X

Equity $12.5 50%Total Assets $25.0 Total Liabilities & Equity $25.0





Cost of capital


Long-lived assets $25.0 Senior Debt $7.5 1.5x 5.50%Subordinated Debt $5.0 1.0X 19.00%

Equity $12.5 50% 30.00%Total Assets $25.0 Total Liabilities & Equity $25.0





Cost of capital


Long-lived assets $25.0 Senior Debt $7.5 1.5x 5.50%Subordinated Debt $5.0 1.0X 19.00%

Equity $12.5 50% 30.00%Total Assets $25.0 Total Liabilities & Equity $25.0


PCOC = 5.5% * (1.5/5) + 19.0% * (1.0/5.0) + 30.0% * (2.5 / 5.0)PCOC = 20.5%

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

• 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

John K. PagliaAssociate Professor of Finance

Senior Researcher, Pepperdine Private Capital Markets Project

Bschool.pepperdine.edu/[email protected]

Thank You!

mailto:[email protected]

Pepperdine Private Cost of Capital 10.08.10

Economy & Finance

net working

asset based

total liabilities

private capital

public capital

equity capital

tax cash flows

equity risk