State of the Middle Market Today 10.25.10

The State of the Middle Market TodayyNational Summit for Middle Market Funds

October 25, 2010John K Paglia Senior ResearcherJohn K. Paglia, Senior Researcher,

Denney Academic Chair, and Associate Professor of Finance

Agenda• Overview of Pepperdine Private Capital Markets

Project• Insights from Various Segments• Insights from Various Segments

– Banks– Mezzanine– Private Equityq y

• The Road Ahead: 12 Month Outlook• Panel Discussion

– Tom Hiatt, Centerfield Capital Partnerso att, Ce te e d Cap ta a t e s– Preston Walsh, PNC Mezzanine Capital– Rob Zielinski, Riordan, Lewis & Haden Equity Partners– Greg Greenburg, Altus Capital Partners

• Questions and Answers

• What is cost of capital for privately-held businesses?

Pepperdine Private Capital Markets Projectp p y

• Project launched in 2007; first semi-annual report published in July 2009

• Survey 12 segments including limited partners, privately-held business owners, capital providers, intermediaries, and appraisers

• Typical survey asks about firm profile, behavior, historical returns expected returns view of next 12 monthsreturns, expected returns, view of next 12 months

• Capital providers last surveyed in September 2010. Report to be available mid-November at http://bschool.pepperdine.edu/privatecapitalp p pp p p

How Are Investments Evaluated in the

90.0%

100.0%85%

82%89% 93%

Private Markets?

50 0%

60.0%

70.0%

80.0% 76%

49%

66%

20.0%

30.0%

40.0%

50.0%

15% 21%

11%

0.0%

10.0%

Payback Internal Rate of Return (IRR)

Discounted Cash Flow (DCF)

Multiple Analysis

Market Analysis

Option Analysis

Decision trees Simulation Analysis (i.e., Monte Carlo

Scenario Analysis

Gut feel

(IRR) (DCF) Monte Carlo methods)Angel VC PE Mezz Business Average

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

Factors(39‐75%)

VCs(25‐40%)

Angels(30‐60%)

Banks ABLs (4‐18%)

Mezz(18‐22%)

PEGs(20‐30%)

(3‐6%)( )

Banks: Today vs 6 Months Ago• No increase in business confidence/conditions

Banks: Today vs. 6-Months Ago

• Demand for loans up but increases in underwriting standards and covenant tightness

• Slight decline in standard advance rates and increased• Slight decline in standard advance rates and increased focus on collateral as backup means of payment

• Increases in senior and total leverage multiples

Banks: Loan Sizes and Motivations35%

34.9% 34.9%

Largest concentrations of

10%15%20%25%30%35%

14.3%

27.0% 27.0%

19.0%14.3%

Largest concentrations of loan sizes were between $1 million and $50 million

38 1%12.2%

2.5% Refinancing

Management buy‐out

0%5%10%

< $1M $1M ‐$5M

$5M ‐$10M

$10M ‐$25M

$25M ‐$50M

$50M ‐$100M

$100M ‐$500M

> $500M

1.6%

38.1%

10.0%14.7%

1.1%

14.7%Financing growth

Chapter 11 workout

Acquisition loan

Debtor‐in‐possession

Working capital fluctuations

Refinancing accounted for nearly 40% of all lending activity followed by acquisitions (15%)

4.3%2.4%

g p

Equipment or building

Other

by acquisitions (15%)

Banks: Senior Leverage MultiplesBusiness Services 1st Quartile Median 3rd Quartile$1M 1.2 1.2 1.9$5M 2.5 2.5 3.0

Approximately 1.2X –2.5X under $10M in 

$10M 2.5 2.5 3.0$25M 2.5 3.0 3.0$50M 2.6 3.0 3.0$100M 3.1 3.3 3.4

EBITDA; 3X and above greater than $10M

Manufacturing 1st Quartile Median 3rd Quartile$1M 1.3 1.3 2.0$5M 2.1 2.5 3.0$10M 2 4 2 5 3 0

Approximately 1.3X –2.5X under $10M in EBITDA 3X and above$10M 2.4 2.5 3.0

$25M 2.6 3.0 3.0$50M 2.5 3.0 3.0$100M 2.3 3.0 3.2

EBITDA; 3X and above greater than $10M

Generally about ½ turn higher except in $1M (down from 1 5)Generally about ½ turn higher except in $1M (down from 1.5)

Banks: All in Rates on Cash Flow LoansCash flow loan all‐in‐Rate (%)

$1 million1st Quartile 5.4 Median 6.5 3rd Quartile 7 1

Median all‐in‐rates from 5% to 6.5% depending on size; 

3rd Quartile 7.1 $5 million

1st Quartile 5.0 Median 5.5 3rd Quartile 6.0 

$10 illi

some as low as 3.5% 

Rates correspond to loan terms of 36 months (median)$10 million

1st Quartile 4.5 Median 5.5 3rd Quartile 7.0 

$25 million1 t Q til 3 8

terms of 36 months (median) within range of 30 – 60 months (1st and 3rd quartile)

1st Quartile 3.8 Median 5.5 3rd Quartile 7.2 

$50 million1st Quartile 3.5 M di 5 0

Rates generally flat except up 50 b.p. for $1 million

Median 5.0 3rd Quartile 7.4 

Banks: The Next 12 Months• Sharp increase in demand for loans

Banks: The Next 12 Months

• Underwriting standards slightly more stringent while credit quality of borrowers continues to improveimprove

• Further increases in senior/total leverage multiples• Collateral remains in focus• See confidence and conditions improving

Mezzanine: Today vs 6 Months Ago• Demand for business investment up

Mezzanine: Today vs. 6-Months Ago

• Increases in investment standards, credit quality of borrowers, appetite for risk

• Deal senior leverage and total leverage multiples up• Deal, senior leverage, and total leverage multiples up• Time to exit investments slightly longer

Mezzanine: Current ActivityNearly 70% of respondents reported making a deal in last 6 months; approximately 30% reported no t ti

30%

4%

5% 9%

2% 4% 2% 2% 01234

transactions

47.7% 53.8%

24.6%12 3%

30.0%40.0%50.0%60.0%

14%14%

14% 568101116 or more

0% 4% Refinancing

1.5%12.3% 6.2% 3.1%

0.0%10.0%20.0%

25%

21%14%

28%

7%Refinancing

Management buy‐out

Financing growth

Chapter 11 workout

Acquisition loan

Most investments in $1 million to $25 million range; Acquisition loan investments accounted for 28% of activity, followed by

14%

1%

Debtor‐in‐possession

Dividend recap

Other

refinancing (25%) and MBO (21%)

Mezzanine: Pricing

$1M $5M $10M $25M1st Q 12 4% 12 0% 12 3% 12 0%

$1M $5M $10M $25M1st Q 13 3% 12 0% 12 0% 11 8%

Sponsor Transactions Non‐Sponsor TransactionsInterest Rate (%)

1st Q 12.4% 12.0% 12.3% 12.0%Median 13.3% 12.8% 13.0% 12.0%3rd Q 13.6% 13.0% 13.0% 12.0%

1st Q 13.3% 12.0% 12.0% 11.8%Median 14.0% 14.0% 12.0% 12.0%3rd Q 14.0% 14.0% 13.0% 12.8%

PIK (%)$1M $5M $10M $25M

1st Q 3.3% 2.0% 2.0% 2.6%Median 3.5% 3.0% 2.0% 2.9%3rd Q 3.8% 4.0% 3.0% 3.0%

$1M $5M $10M $25M1st Q 2.0% 1.0% 2.0% 2.5%Median 2.0% 2.0% 2.0% 3.0%3rd Q 2.0% 2.0% 2.8% 3.0%

TotalReturns $1M $5M $10M $25M1st Q 18.0% 17.5% 17.3% 17.9%Median 20 0% 20 0% 18 9% 18 5%

TotalReturns $1M $5M $10M $25M1st Q 23.0% 22.0% 20.0% 17.8%Median 24 0% 22 0% 20 0% 18 0%

Total Returns (%)

Median 20.0% 20.0% 18.9% 18.5%3rd Q 22.0% 22.3% 20.0% 19.0%

Median 24.0% 22.0% 20.0% 18.0%3rd Q 24.5% 24.0% 21.3% 18.5%

Mezzanine: Total Leverage and Time to ExitMezzanine: Total Leverage and Time to Exit

Total Leverage Ratios (x EBITDA)

$1M $5M $10M $25M1st Q 2.9  3.5  3.5  4.4 Median 3.5  3.5  4.0  4.8 3rd Q 4.1  4.0  4.0  5.0 

Represents additional 1 – 2 turns of EBITDA (after senior), increasing with size; relatively flat from 6 months ago 

$25M f 4 5X

$1M $5M $10M $25M

except $25M up from 4.5X

Time to Exit (Months)$ $ $ $

1st Q 36  48  48  33 Median 48  54  60  36 3rd Q 63  60  60  42 

Looking to exit in 3‐5 years

Mezzanine Investments: Next 12 Months

5%

2% 2%

11%2%

4% 2%5%

7%

4%012345

Largest concentration of responses indicate plan for four transactions in 

( )29%

13%

14%567891012

next 12 months (29%); 56% are planning between four and six

6.0% 1.4%0.7%4.2% 1.4%

0.4%1.2%1.4%2.8% 6.2% Consumer services

RestaurantHealthcareLife sciences

1216 or more

Business services (25.4%), 12.2% 3.1%

2.4%

25.4%21.5%

9.1%0.8%

Life sciencesRetailReal estateBusiness servicesManufacturingWholesale and distributionFinance, insurance, and relatedInformation and technologyM di d t t i t

manufacturing (21.5%), and healthcare (12.2%) look to be areas targeted for investment; manufacturing down from 27 8% Media and entertainment

Agriculture and miningEngineering and constructionTransportationOil, gas, and other utilities

manufacturing down from 27.8% 

Mezzanine: A View to the Next 12 Months

• See increases in demand for business investment credit

Mezzanine: A View to the Next 12 Months

See increases in demand for business investment, credit quality of borrowers up, increasing appetite for risk, and investment standards stabilizing

• Deal, senior leverage, total leverage multiples increasing further

• See size of industry increasing• See size of industry increasing• Sees improvement in returns Last 12 

months Next 12 months

1st Quartile 7.3% 12.0%di % %Median 15.0% 18.0%

3rd Quartile 19.3% 22.0%

P i t E it T d 6 M th APrivate Equity: Today versus 6 Months Ago

• Demand for business investment is up as are investmentDemand for business investment is up, as are investment standards, appetite for risk, and quality of companies seeking investment

• Leverage and deal multiples increased; exit times longer• Increased ability to assess and price risk• General contraction in size of industry• General contraction in size of industry• Communication with and power of LPs has increased

Private Equity: Current Activity

32.7%6.1%3.4%

3.4%1.4%0.7%

0.7%1.4%

2.0%0.7%1.4% 0

1

2

3Nearly 68% of respondents reported making a d l i l t 6 th i t l 33%

21.1%

25.2%

4

5

6

7

8

deal in last 6 months; approximately 33% reported no transactions

9

10

12

16 or more

50 0% 43.5%

10 0%

20.0%

30.0%

40.0%

50.0%

3 1%

25.9%30.6%

43.5%

31.6%

21.8%

10.4%4.7%

The largest concentration of checks written was in the $10 ‐ $25 million range (43.5%) followed by $25 ‐ $50 million (31.6%) and $5 ‐ $10 million

0.0%

10.0%

< $1M $1M ‐$5M

$5M ‐$10M

$10M ‐$25M

$25M ‐$50M

$50M ‐$100M

$100M ‐$500M

> $500M

3.1%million (31.6%) and $5  $10 million (30.6%)

Private Equity: Deal Multiples and Equity C t ib tiContributions

EBITDA  1st  Median 3rd  Median equityQuartile Quartile

$1M 38.8% 60.0% 82.5%$5M 40.0% 60.0% 70.0%$10M 50.0% 57.5% 61.6%

Median equity contributions reported range from a high of 60% for smaller transactions to 

$25M 25.0% 47.5% 60.0%$50M 21.3% 32.5% 40.0%$100M 10.0% 20.0% 22.5%

20% for larger companies; improved > $10 million

EBITDA  1st Quartile Median 3rd QuartileQ Q

$1M 3.9  4.0  5.3 

$5M 4.5  5.0  5.7 

$10M 5.0  6.0  7.0 

Deal multiples range from a median of 4X EBITDA to 7.5X for transactions with $50 million EBITDA $25M 5.5  6.0  7.8 

$50M 7.5  7.5  8.0 

EBITDA

Private Equity: Expected Returns and Exit TiTimes

EBITDA  1st Quartile Median 3rd Quartile Expected gross annual returns on $1M 25.0% 30.0% 35.0%

$5M 25.0% 30.0% 30.0%

$10M 24.5% 30.0% 31.3%

new investment range from a median of 25% for larger transactions to 30% for smaller ones

$25M 25.0% 28.0% 30.0%

$50M 22.0% 25.0% 30.0%

ones

EBITDA 1st Quartile

Median 3rd QuartileQ Q

$1M 48.0  60.0  60.0 $5M 48.0  60.0  60.0 $10M 36.0  48.0  48.0 $25M 37.0  48.0  60.0 $

Expected exit times range from 48 months for larger transactions to 60 months for smaller ones

$50M 48.0  48.0  60.0 $100M 48.0  48.0  48.0 

Private Equity Investing: Next 12 Monthsq y g4%

9%4% 8%

1% 2% 1%2%1%1% 3% 0

1234

Nearly 2/3 (64%) are looking to make 2 – 4 investments in the next year and approximately 12% of those will be in distressed assets (prior was 17 9%)

Distressed as a % of total # of transactions 12.3%Distressed as a % of total VALUE of transactions 10.0%

30%

23%

11% 5678101214

be in distressed assets (prior was 17.9%)

6.0% 1.2%

11.2% 1.8%2 2%6.2%

3.3%

1.8%0.9%

1.6%1.7% 4.6%

3.6% Consumer servicesRestaurantHealthcareLife sciencesRetailReal estate

1516 or more

Manufacturing (22.7%, from 2.2%2.3%

16.7%

22.7%6.3%

6.0%

Real estateBusiness servicesManufacturingWholesale and distributionFinance, insurance, and relatedInformation and technology Clean / green technologyMedia and entertainment

Manufacturing (22.7%, from 25.5%), business services (16.7%), and healthcare (11.2%, from 8%) appear to be the targets of nearly h lf f ll i t t Media and entertainment

Agriculture and miningEngineering and constructionTransportationOil, gas, and other utilitiesOther

half of all investments

Private Equity: A 12-Month View

• See increases in demand for business investment, standards, quality of companies seeking investment, increasing appetite q y p g g ppfor risk

• Greater ability to assess and price riskD l i l t t l l lti l i i• Deal, senior leverage, total leverage multiples increasing further

• Communication with and power of LPs increasing furtherp g• More contraction in size of PE industry• See improvement in returns Last 12 

months Next 12 months

1st Quartile 18.0% 22.0%Median 25.0% 27.0%3rd Quartile 35.5% 35.0%

General Survey Insights Across All Segments• What is the #1 issue facing privately-held businesses today?

– Limited access to capital (40%)

y g g

p ( )– Government regulations (taxes, healthcare, etc.) (30%)– Economic environment / uncertainty (20%)

• What is the #1 emerging issue facing privately-held• What is the #1 emerging issue facing privately-held businesses?– Tighter government regulations (35%)

Li it d t it l (25%)– Limited access to capital (25%)– Economic environment / uncertainty (14%)

General Survey Insights: Private Equity, Mezzanine,

• What are the significant trends and developments in private

and Venture Capital

What are the significant trends and developments in private equity?– Risk aversion / stricter investing requirements (21% mezzanine, 22%

venture capital 17% private equity)venture capital, 17% private equity)– Businesses facing lower demand / increasing competition / lower

margins (21% mezzanine, 22% venture capital, 17% private equity)Government regulations (12% mezzanine 14% venture capital 17%– Government regulations (12% mezzanine, 14% venture capital, 17% private equity)

What about the Businesses?• Compared to six months ago...

– Time to collect receivables is upOwner compensation is down– Owner compensation is down

– Competitive pressures are up– CAPEX is flat, as are other expenses

Opportunities for growth are up sharply but– Opportunities for growth are up sharply, but...– Access to growth capital is down!

• Who can help? LPs say PE (48%) and Mezzanine (33%) offer best i k/ t t d ff !risk/return tradeoffs!– PE returns at 17.0%– Mezz returns at 12.1%

11%

33%48%

8%

Venture Capital

Mezzanine Investment

Private Equity48% Private Equity

Hedge Fund

The Road Ahead• Economic View

– GDP at 1.1%P b bilit f d bl di i t 35%– Probability of double-dip recession at 35%

• Industry View– Mezzanine and private equity favorite asset classes– Deal flow increasing– Leverage and deal multiples increasing

• Business View– Desperate for growth capital– Many owners still waiting to sell

Thank You!John K. Paglia

Thank You!John K. Paglia

Associate Professor of FinanceSenior Researcher Pepperdine PrivateSenior Researcher, Pepperdine Private

Capital Markets Projectbschool.pepperdine.edu/privatecapital

[email protected]