pepperdine cost of capital national summit 10 18 2011
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New insights and data on pricing capital in today’s competitive environment from the Pepperdine Private Capital Markets Project show challenges remain for lenders, investors and the private business that depend on them. Lead researcher John Paglia presented at the National Summit for Middle Market Funds.TRANSCRIPT
The Cost of Capital... An Update and New Details on the Pepperdine Data
John K. Paglia, Ph.D., CFA, CPA
National Summit for Middle Market FundsOctober 18, 2011
Dow Jones Industrial Average (2007 – 2011)
Dow Jones Industrial Average (2007 – 2011)
Dow Jones Industrial Average (2007 – 2011)
• State of Financing for Privately-Held Businesses
• Insights from Various Segments– Banks– Asset Based Lenders– Mezzanine– Private Equity– Investment Bankers– Limited Partners
• Summary and Conclusion
Agenda
• What is cost of capital for SMEs?• The project launched in 2007; first report in July
2009• We now survey 12 segments • Certificate in Private Capital Markets (3-day
curriculum based educational program) offered again in Malibu, CA November 14-16; Use “paglia” for discount code to get $300 off
• Reports to be available by mid-November at http://bschool.pepperdine.edu/privatecapital
Pepperdine Private Capital Markets Project
0%
10%
20%
30%
40%
50%
60%
70%
Pepperdine Private Cost of Capital LineExpected Returns by Capital Providers on New Investments
Fall 2011
1 quartile Median 3 quartile Median Spring 2011
Banks (5 ‐ 7%)ABL (3% ‐ 7%)
PEG (21% ‐ 26%)
VC (28% ‐ 38%)
Mezz (11% ‐ 16%)
Angel (38% ‐ 47%)
Incomeapproach(DCF, NPV,
IRR)
Transactionapproach
Publiccompanyapproach
Asset basedapproach Other
Average 29% 29% 12% 9% 23%Angel 14% 21% 8% 5% 51%VC 15% 40% 16% 5% 23%PEG 34% 27% 16% 12% 9%Brokers 30% 34% 5% 13% 18%Ibanker 34% 34% 15% 11% 6%Appraisers 50% 20% 13% 10% 8%
29% 29%
12% 9%
23%
0%
10%
20%
30%
40%
50%
60%
How Are Investment Valuation Techniques Weighted in the Private Markets?
RecastEBITDAmultiple
EBITDAmultiple
Cash flowmultiple
Revenuemultiple
Netincomemultiple
EBITmultiple Other
Average 33% 20% 17% 14% 6% 6% 4%PEG 25% 30% 18% 10% 6% 6% 3%Brokers 34% 15% 24% 12% 5% 4% 7%Ibanker 40% 22% 13% 13% 7% 5% 3%Appraisers 32% 13% 16% 21% 7% 6% 4%
33%
20%17%
14%
6% 6% 4%
0%5%10%15%20%25%30%35%40%45%
Weight o
f Use (%
)
Which Multiples are Used to Determine the Value of a Business?
Source: Pepperdine Private Capital Markets Project Fall 2011 Business Owner Survey, Pepperdine University
Deal and Leverage Multiples
$1MEBITDA
$5MEBITDA
$10MEBITDA
$25MEBITDA
$50MEBITDA
$100MEBITDA
Deal multiples 4 4.5 5.5 6 6.5 7Senior leverage 2.25 2.25 2.5 3 3 3Total leverage 3.5 3.5 4 4.5 4.75 5
4.04.5
5.56.0
6.57.0
2.3 2.3 2.53.0 3.0 3.0
3.5 3.5 4.04.5 4.8 5.0
0
1
2
3
4
5
6
7
8Multip
le of E
BITD
A
What is the Status of Privately-Held Businesses
as of Fall 2011?
• Significant increases in prices of labor and materials
• Increases in unit sales, net income, opportunities for growth
• Receivables periods lengthening
• General business conditions declining while significant increase in time worrying about economy
Businesses: Today vs. 6-Months Ago
• Nearly 91% of business owners report having the enthusiasm to execute growth strategies
• Yet just 49% report having the necessary financial resources to successfully execute growth strategies
What is the State of Financing?
Source: Pepperdine Private Capital Markets Project Fall 2011 Business Owner Survey, Pepperdine University
Source: Pepperdine Private Capital Markets Project Fall 2011 Business Owner Survey, Pepperdine University
38%
26%
25%
3%2% 2%
5%
Economic uncertainty (domestic)
Access to capital
Government regulations and taxes
Inflation
Economic uncertainty(international)Competition from foreign tradepartnersOther
Top Issues Facing Privately–Held Businesses
47%
30%
19% 19%
3% 3% 2% 1% 1% 0.3% 0.3%8%
‐10%
0%
10%
20%
30%
40%
50%
60%
Freq
uency (%
)Business Owners’ Current Sources of
Financing (All sizes)
Business Owners’ Current Sources of Financing (>$5 million revenues)
53%
38%
16%
8% 9%3% 5%
2% 2% 1.4% 0.5%
9%
0%
10%
20%
30%
40%
50%
60%
Business Owners’ Estimates of Cost of Equity (by Revenue Size)
23%19%
19%17%
15% 15% 14% 14%
17%15% 15%
15%13% 13%
11% 11%
0%
5%
10%
15%
20%
25%
Less than$1 million
$1 million ‐$5 million
$5million ‐$10 million
$10 million‐ $25million
$25 million‐ $50million
$50 million‐ $100million
$100 ‐ $500million
Greaterthan $500million
Cost of E
quity
(%)
Mean Median
Small Business Financing Success RatesFor Twelve Month Period Ended September 16, 2011
Avg. Friends Creditcard Factor Bank Angel ABL Mezz. Hedge PEG VC
Less than $5M 51% 78% 63% 47% 44% 41% 38% 25% 23% 23% 20%$5M ‐ $25M 64% 90% 85% 58% 72% 25% 61% 25% 8% 44% 30%Greater than $25M 83% 94% 91% 67% 90% 40% 79% 77% 57% 74% 45%
83%94% 91%
67%
90%
40%
79% 77%
57%
74%
45%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Source: Pepperdine Private Capital Markets Project Fall 2011 Business Owner Survey, Pepperdine University
3.2
5.34.8
4.03.6 3.4
2.4 2.4 2.3 2.3 2.0
0.0
1.0
2.0
3.0
4.0
5.0
6.0
Persistence Pays… Average Number of Capital Providers Contacted for
Successful Financing Outcome
Business Owners’ Expected Time to Exit (>$5 million revenues)
3% 2%
5% 6%
3%
11%
25%
16%
6%
23%
0
0.05
0.1
0.15
0.2
0.25
0.3
< 1 year 1 year 2 years 3 years 4 years 5 years 5‐10years
10‐15years
15‐20years
>20years
Percen
tage (%
)
About 30% within next five years
• Significant increases in unit sales along with product/service pricing and prices of labor and materials increases
• Increases in net income, opportunities for growth
• Receivables periods lengthening
• No improvement in general business conditions and further increase in time worrying about economy
Businesses with Revenues >$5M: The Next 12 Months
What’s Happening with Capital Providers?
• Worsened business conditions and appetite for risk
• Demand for loans and underwriting standards flat (despite more due diligence) with slight increase in credit quality of borrowers
• Increased focus on collateral as backup means of payment; personal guarantee coverage flat, but starts to burn off around $5 million in loan size
• Highly competitive for quality companies; pricing and loan structures back to pre-crash levels
Banks: Today vs. 6-Months Ago
Banks: Loan Sizes Underwritten
Largest concentrations of loan sizes were between $1 million and $25 million
24%
51%
36%40%
29%25%
0%
10%
20%
30%
40%
50%
60%
Less than $1M $1M ‐ 5M $6M ‐ $10M $11M ‐ 25M $25M ‐ $50M Greater than$50M
Banks: Motivations for Loans
Refinancing accounted for nearly 49% of all lending activity followed by expansion (22%), working capital (11%)
49%
22%
11%10%
5% 4%Refinancing existing loans or equityExpansion
Working capital fluctuations
Management buy‐out
Finance worsening operating conditionsOther
Banks: Increased Pressure from Regulators to Avoid Making Risky Loans?
82%
13% 4%
AgreeNeutralDisagree
Banks declined 63% of cash flow based loans over prior six months
Banks: Senior Leverage Multiplesfor Business Services Companies
Approximately 1.5X – 2.5X under $25M in EBITDA; 3X and above greater than $25M
1st Quartile Median 3rd Quartile
EBITDA Spring 2011 Fall 2011 Spring
2011 Fall 2011 Spring 2011 Fall 2011
$1M 1.2 1.3 1.2 1.5 1.9 2.0
$5M 2.5 1.4 2.5 2.0 3.0 2.4
$10M 2.5 2.4 2.5 2.5 3.0 3.0
$25M 2.5 2.4 3.0 2.5 3.0 3.0
$50M 2.6 2.5 3.0 3.0 3.0 3.3
$50M 3.1 2.6 3.3 3.0 3.4 3.4
Banks: Senior Leverage Multiplesfor Manufacturing Companies
Approximately 1.8X – 2.5X under $25M in EBITDA; 2.5X and above greater than $25M
1st Quartile Median 3rd Quartile
EBITDA Spring 2011 Fall 2011 Spring
2011 Fall 2011 Spring 2011 Fall 2011
$1M 1.3 1.5 1.3 1.8 2.0 2.0
$5M 2.1 1.5 2.5 1.8 3.0 2.1
$10M 2.4 2.3 2.5 2.5 3.0 2.8
$25M 2.6 2.4 3.0 2.5 3.0 3.0
$50M 2.5 2.5 3.0 3.0 3.0 3.3
$100M 2.3 2.7 3.0 3.3 3.2 3.5
Banks: All in Rates on Cash Flow Loans (%)
Rates correspond to loan terms of 60 months (median)
1st Quartile Median 3rd Quartile
EBITDA Spring 2011 Fall 2011 Spring
2011 Fall 2011 Spring 2011 Fall 2011
$1 million 5.4 5.5 6.5 7.0 7.1 7.0
$5 million 5.0 5.8 5.5 6.0 6.0 6.0
$10 million 4.5 5.0 5.5 5.5 7.0 5.5
$25 million 3.8 4.8 5.5 5.5 7.2 6.5
$50 million 3.5 3.8 5.0 4.0 7.4 6.5
Slight increase in all-in-rates on cash flow loans over the last 6 months, except for large companies
Banks: Financial Evaluation Metrics (Medians)
Average Borrower Approval Limits Importance
Score (0‐4) Spring 2011
Fall 2011
Spring 2011
Fall 2011
Spring 2011
Fall 2011
Current ratio 1.4 1.4 1.3 1.1 1.7 1.6Total debt service coverage ratio 1.3 1.3 1.3 1.2 3.7 3.5
Total debt to cash flow 2.5 2.8 2.8 4.0 3.2 3.0
Debt to net worth 2.0 2.0 2.4 3.0 2.5 2.2
Approval thresholds in Fall 2011 are lower than in Spring 2011 but average borrower characteristics are relatively constant
• Sharp increase in demand for loans, lending capacity of banks and SBA lending
• Underwriting standards and credit quality of borrowers relatively flat
• Further increases (slight) in senior/total leverage multiples
• Relatively flat business conditions• Increasing due diligence efforts and further
pricing compression
Banks: The Next 12 Months
What’s Happening with Asset Based Lenders?
• Increased demand for loans• Slight increase in standard advance rates on
collateral• Compressed loan fees and spreads• Increase in loans outstanding• Slight decline in business conditions
ABLs: Today vs. 6-Months Ago
ABLs: Loan Sizes Underwritten
Largest concentrations of loan sizes were between $1 and $5 million (48%)
16%
48%
28%24%
28%
16% 16%
8%
0%
10%
20%
30%
40%
50%
60%
Less than$1M
$1M ‐ 5M $5M ‐$10M
$10M ‐25M
$25M ‐$50M
$50M ‐$100M
$100M ‐$500M
Greaterthan
$500M
ABLs: Motivations
Refinancing accounted for nearly 55% of all lending activity followed by worsening operations conditions (13%) and working capital (13%)
55%
17%
13%
13%
5%Refinancing
Finance worsening operations conditions
Fluctuating working capital
Expansion
Other
ABLs: Advance Rates
Typical Loan (Median %) Upper Limit (Median %) Spring 2011 Fall 2011 Spring 2011 Fall 2011
Marketable securities 80 90 90 90
Accounts Receivable 80 85 85 85
Inventory ‐ Low quality 25 25 40 30Inventory ‐ Intermediate quality 40 45 50 50
Inventory ‐ High quality 55 60 60 60Equipment 60 75 80 75Real Estate 60 65 70 70Land 50 40 50 42
On average, advance rates are slightly higher than 6 months ago
6%
63%
87%
10%
35%
33%
44%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Purchase price
Depreciated Value (Book)
Face value
Fair Market Value
Forced Liquidation
Orderly Liquidation
Other
Equipment Real estate Accounts Receivable Inventory
ABLs: Collateral Valuation Standards
ABLs: All in Rates (%)Type and Size 1st Quartile Median 3rd Quartile
Spring 2011
Fall 2011
Spring 2011
Fall 2011
Spring 2011
Fall 2011
WORKING CAPITAL$5M 5.0 6.8 7.0 9.3 11.0 12.0$25M 3.0 3.8 3.4 4.9 4.4 10.5$50M 3.0 2.8 3.3 3.0 4.0 3.3$100M 2.6 2.5 3.0 2.8 3.4 3.1EQUIPMENT$5M 5.3 5.5 7.3 6.5 8.9 6.5$25M 3.9 3.4 5.8 3.6 7.1 3.9$50M 3.5 2.6 4.0 2.8 5.6 3.1$100M 3.4 2.5 4.0 2.5 4.6 2.5
All-in-rates are lower than 6 months ago except small size lending with working capital as a collateral
ABLs: Financial Evaluation Metrics (Medians)
Average Borrower
Approval Limits
Importance Score (0‐4)
Spring 2011
Fall 2011
Spring 2011
Fall 2011
Spring 2011
Fall 2011
Current ratio 1.0 1.7 1.0 1.2 1.1 0.9Total debt service coverage ratio 1.2 1.1 1.0 1.0 2.6 2.4
Total debt to cash flow 3.5 3.0 3.8 4.0 2.4 2.3Debt to net worth 2.1 2.8 2.5 2.7 2.1 1.7Revenue growth rate 1.1% 5.0% 1.0% 5.0% 1.5 1.8
• Sharp increase in demand for loans and loans outstanding
• Underwriting standards slightly more stringent but credit quality of borrowers will continue to improve
• See business conditions generally flat• Relatively flat pricing
ABLs: The Next 12 Months
What’s Happening with Mezzanine Capital?
• Demand for mezzanine financing up• Increased credit quality of borrowers• Warrant coverage down, deal and leverage
multiples up, expected returns down with more competition
• Time to exit investments slightly longer• Underwriting standards relatively flat• Significant decrease in general business
conditions
Mezzanine: Today vs. 6-Months Ago
Mezzanine: Loan Sizes Underwritten
6%
39%
58%
37%
18%
10%5%
0%
10%
20%
30%
40%
50%
60%
70%
Less than$1M
$1M ‐ 5M $5M ‐$10M$10M ‐25M $25M ‐$50M
$50M ‐$100M
$100M ‐$500M
Largest concentrations of loan sizes were between $5 and $10 million (58%)
Mezzanine: Loan Motivations
Acquisition loan investments accounted for 29% of activity, followed by MBO (28%), refinancing (15%) and growth (15%)
29%
28%
15%
15%
5% 2%Acquisition loan
Management buyout
Refinancing
Financing growth
Working capital fluctuations
Finance worsening operations conditions
Mezzanine: To Make One Investment…
40
106
2
60
15
82
0
10
20
30
40
50
60
70
Plans Reviewed Meetings Proposal Letters LOI
Median Average
Mezzanine: Interest Rates (%)Sponsor Transactions
1st Quartile (%) Median (%) 3rd Quartile (%)
EBITDA Size Spring 2011 Fall 2011 Spring
2011 Fall 2011 Spring 2011 Fall 2011
$1M 12 12 13 12 14 13$5M 12 12 13 12 13 13$10M 12 11 13 12 13 12$25M 12 10 12 11 12 12$50M 10 11 12$100M 7 11 12
Mezzanine interest rates for sponsor transactions are lower than 6 months ago
Mezzanine: PIK (%)Sponsor Transactions
1st Quartile (%) Median (%) 3rd Quartile (%)
EBITDA Size Spring 2011 Fall 2011 Spring
2011 Fall 2011 Spring 2011 Fall 2011
$1M 3 1 4 1 4 2$5M 2 1 3 3 4 3$25M 3 3 3 4 3 4$50M 4 4 4
Mezzanine: Total Expected Returns (%)Sponsor Transactions
1st Quartile (%) Median (%) 3rd Quartile (%)
EBITDA Size Spring 2011 Fall 2011 Spring
2011 Fall 2011 Spring 2011 Fall 2011
$1M 18 16 20 20 22 21$5M 18 19 20 20 22 26$10M 17 15 19 18 20 20$25M 18 12 19 16 19 20$50M 13 14 15$100M 7 13 16
Mezzanine total returns decreased for $10 million and $25 million loans in the last 6 months
Mezzanine: Interest Rates (%)Non-Sponsor Transactions
1st Quartile (%) Median (%) 3rd Quartile (%)
Spring 2011 Fall 2011 Spring
2011 Fall 2011 Spring 2011 Fall 2011
$1M 13 10 14 12 14 14$5M 12 12 14 12 14 14$10M 12 12 12 12 13 14$25M 12 10 12 12 13 13
Mezzanine interest rates for non-sponsor transactions are slightly lower than 6 months ago
Mezzanine: PIK (%)Non-Sponsor Transactions
1st Quartile (%) Median (%) 3rd Quartile (%)
Spring 2011 Fall 2011 Spring
2011 Fall 2011 Spring 2011 Fall 2011
$1M 2 2 2 2 2 2$5M 1 2 2 2 2 2$25M 3 2 3 3 3 3$50M 2 3 3
Relatively constant percentages
Mezzanine: Total Expected Returns (%)Non-Sponsor Transactions
1st Quartile (%) Median (%) 3rd Quartile (%)
Spring 2011 Fall 2011 Spring
2011 Fall 2011 Spring 2011 Fall 2011
$1M 23 17 24 19 25 20$5M 22 20 22 19 24 25$10M 20 16 20 18 21 25$25M 18 15 18 17 19 21
Mezzanine total returns decreased for almost all loan sizes in the last 6 months
Mezzanine: Total Leverage Ratios
Represents additional 1 – 2 turns of EBITDA (after senior), increasing with size. Relatively constant when compared to Spring 2011.
1st Quartile (%) Median (%) 3rd Quartile (%)Spring 2011 Fall 2011 Spring
2011 Fall 2011 Spring 2011
Fall 2011
$1M 2.9 3.0 3.5 3.5 4.1 3.5$5M 3.5 3.0 3.5 3.5 4.0 4.0$10M 3.5 3.5 4.0 4.0 4.0 4.5$25M 4.4 4.0 4.8 4.5 5.0 5.0$50M 4.0 4.8 5.0$100M 5.0 5.0 5.5
Mezzanine: Time to Exit (Months)
Looking to exit in 5-7 years
Exit times are longer than 6 months ago
1st Quartile Median 3rd QuartileSpring 2011
Fall 2011
Spring 2011
Fall 2011
Spring 2011
Fall 2011
$1M 36 60 48 60 63 60$5M 48 60 54 60 60 60$10M 48 60 60 66 60 72$25M 33 60 36 60 42 72$50M 60 72 78$100M 72 78 84
Mezzanine: Financial Evaluation Metrics (Medians)Average Borrower
Approval Limits
Importance Score (0‐4)
Spring 2011
Fall 2011
Spring 2011
Fall 2011
Spring 2011
Fall 2011
Senior debt service coverage ratio 1.6 1.5 1.3 1.2 3.3 2.4
Total debt service coverage ratio 1.3 1.4 1.2 1.2 2.7 3.3
Senior debt to cash flow 2.5 2.5 3.0 3.0 3.4 2.9
Total debt to cash flow 3.5 4.0 4.0 4.0 3.4 3.6
Mezzanine Investments: Transactions in Next 12 Months
Largest concentration of responses indicates plan for 3 – 5 transactions in next 12 months (39%); 32% are planning between 6 and 10
7%
39%
32%
13%11%
0 to 2
3 to 5
6 to 10
11 to 15
more than 15
Mezzanine Investments: Segments Targeted in Next 12 Months
Business services (22%), manufacturing (21%), and healthcare (14%) look to be areas targeted for investment
22%
21%
14%12%
10%
8%8%
2%3%Business Services
Manufacturing
Health Care
Retail and Consumer Services
Wholesale & Distribution
Information Technology
Basic Materials & Energy
Financial Services
Other
• Increasing demand for mezzanine capital, but flat leverage multiples
• Slight increase in underwriting standards• Relatively flat loan fees, PIK, and warrant
coverage• Significant decrease in general business
conditions• Increasing size of mezzanine industry with
additional competition from business development companies (BDCs) and SBIC funds
Mezzanine: A View to the Next 12 Months
What’s Happening with Private Equity?
Private Equity: Today versus 6 Months Ago
• Increased demand for private equity and increases in quality of companies
• Increased deal multiples, exit times longer• Increased amount of non-control
investments• Decrease in expected returns on new
investments and lower appetite for risk• Worsened general business conditions
Private Equity: Investment Activity in Last Six Months
Nearly 74% of respondents reported making a deal in the last 6 months; approximately 26% reported no transactions
26%
31%17%
11%
7%4% 4% 0
1
2
3
4
5
more than 5
Private Equity: Investment Checks Written
The largest concentration of checks written was in the $10 -$25 million range (35%) followed by $25 - $50 million (33%) and $5 - $10 million (33%)
8%
30%33% 35% 33%
18% 16%
3%
0%
5%
10%
15%
20%
25%
30%
35%
40%
Less than$1 million
$1‐5million
$5‐$10million
$10‐25million
$25‐$50million
$50‐$100million
$100‐$500million
Greaterthan $500million
Private Equity: To Make One Investment…
100
155 2
142
229 2
0
20
40
60
80
100
120
140
160
Plans Reviewed Meetings Proposal Letters LOI
Median Average
Private Equity Balance of Capital with Businesses Worthy of Financing:
Surplus or Shortage?
$1MEBITDA
$5MEBITDA
$10MEBITDA
$15MEBITDA
$25MEBITDA
$50MEBITDA
$100MEBITDA
> $100MEBITDA
Score ‐0.9 ‐0.6 0.1 0.3 0.5 0.6 0.7 0.7
‐0.9
‐0.6
0.10.3
0.5 0.60.7 0.7
‐1.3
‐0.8
‐0.3
0.2
0.7
1.2
Score (‐2
to 2) Relative
Shortage
Private Equity: Difficulty Securing Senior Debt?
$1MEBITDA
$5MEBITDA
$10MEBITDA
$15MEBITDA
$25MEBITDA
$50MEBITDA
$100M+EBITDA
Score ‐0.5 0.4 1.3 1.8 1.7 1.7 2.3
‐0.5
0.4
1.3
1.8 1.7 1.7
2.3
‐1.0
‐0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
Score (‐3
to 3)
Private Equity: Deal Multiples (of EBITDA)
Median deal multiples starting to exhibit weakness
EBITDA 1st Quartile Median 3rd Quartile
Spring 2011 Fall 2011 Spring
2011 Fall 2011 Spring 2011 Fall 2011
$1M 3.9 3.0 4.0 4.0 5.3 5.5$5M 4.5 3.5 5.0 4.5 5.7 6.0$10M 5.0 4.5 6.0 5.5 7.0 7.0$25M 5.5 5.0 6.0 6.0 7.8 7.5$50M 7.5 5.0 7.5 6.5 8.0 8.5
Private Equity: Equity Contributions (%)
Median equity contributions reported range from a high of 60% for smaller transactions to 35% for larger companies
EBITDA 1st Quartile (%) Median (%) 3rd Quartile (%)
Spring 2011 Fall 2011 Spring
2011 Fall 2011 Spring 2011 Fall 2011
$1M 39 45 60 60 83 95$5M 40 45 60 55 70 85$10M 50 38 58 50 62 55$25M 25 35 48 45 60 53$50M 21 25 33 35 40 35$100M 10 35 20 35 23 55
Private Equity: Expected Returns (%)
Expected gross annual returns on new investment range from a median of 25% for most large transactions to 30% for smaller ones
Expected returns are significantly lower than 6 months ago
EBITDA 1st Quartile (%) Median (%) 3rd Quartile (%)Spring 2011 Fall 2011 Spring
2011 Fall 2011 Spring 2011 Fall 2011
$1M 25 25 30 30 35 38
$5M 25 23 30 25 30 35
$10M 25 23 30 25 31 30$25M 25 23 28 25 30 30$50M 22 23 25 25 30 30$100M 23 25 27$500M 21 23 27
Private Equity: Exit Times (Months)
Expected exit times range from 48 months for larger transactions to 60 months for smaller ones
EBITDA 1st Quartile Median 3rd QuartileSpring 2011 Fall 2011 Spring
2011 Fall 2011 Spring 2011 Fall 2011
$1M 48 48 60 60 60 60
$5M 48 48 60 60 60 60
$10M 36 46 48 60 48 60
$25M 37 40 48 48 60 51
$50M 48 30 48 48 60 48
$100M 48 48 48 48 48 60
$500M 48 48 60
Private Equity Investing: Number of Transactions in Next 12 Months
60% are looking to make 2 – 3 investments in the next year
2%
9%
30%
30%
9%
6%5%
8%
0
1
2
3
4
5
6
more than 6
Private Equity Investing: Segments Targeted in Next 12 Months
Manufacturing (19%), business services (16%), healthcare (12%), and retail & consumer services (12%) appear to be the targets of 59% of investments
19%
16%
12%12%9%
7%
6%6% 13%
Manufacturing
Business Services
Health Care
Retail & Consumer Services
Basic Materials & Energy
Wholesale & Distribution
Financial Services
Information Technology
Other
• Increasing demand for private equity and quality of companies seeking investment
• Increasing amount of non-control investments• Deal multiples increasing further• Generally flat to slightly lower expected
returns on new investments• Worsening general business conditions and
lower appetite for risk
Private Equity: A 12-Month View
What are Investment Bankers Experiencing?
Investment Bankers: Today vs. 6-Months Ago
• Deal flow up slightly• Relatively flat leverage and deal multiples• Extended time / increased difficulty to sell
business• Increased presence of strategic buyers• Increased margin pressure on companies• Worsened business conditions
Investment Banks: Business Sales Transactions in Last 6 Months
75% report making at least one deal in last 6 months; 51% made between 1 – 3 while 25% didn’t make any
25%
24%20%
7%
6% 6%3% 9%
0
1
2
3
4
5
6
more than 6
Investment Banks: Time to Transact Businesses in Last 6 Months
The largest concentration of transactions closed in 6-8 months (29%); another 22% closed in 4-6 months
7%
22%
29%13%
16%9%
4% 2 ‐ 4 months
4 ‐ 6 months
6 ‐ 8 months
8 ‐ 10 months
10 ‐ 12 months
12 ‐ 18 months
more than 18 months
Investment Bankers: Percentage of Deals with …
32.8%
31.9%
31.1%
30.7%
29.0%
29.5%
30.0%
30.5%
31.0%
31.5%
32.0%
32.5%
33.0%
33.5%
Seller Financing /Seller Note
Contingentearnout
Adjusted amountof equity sold
Lowered multipleof EBITDA
Freq
uency (%
)
Investment Banks: Are Strategics Outbidding Financial Buyers?
Roughly 19% report that strategic buyers didn’t pay premiums relative to financials’ offers; 23% report premiums less than 10% and another 28% report premiums between 11-20%
19%
23%
28%
13%
3%2%13%
No
Yes, 0‐10% more
Yes, 11‐20% more
Yes, 21‐30% more
Yes, 31‐40% more
Yes, 41‐50% more
Yes, >50% more
Investment Banks: 43% of Engagements Expired Without Transaction! Why?
37% report valuation gap of less than 20%; 39% report 21 – 30% valuation gap
29%
18%17%
14%
8% 6%6% 2%
Valuation gap in pricing
Economic uncertainty
Unreasonable seller or buyer demand
Lack of capital to finance
No market for business
Other
Insufficient cash flow
Seller misrepresentations
Investment Bankers: Difficulty Securing Senior Debt?
$1MEBITDA
$5MEBITDA
$10MEBITDA
$15MEBITDA
$25MEBITDA
$50MEBITDA
$100M+EBITDA
PEGs ‐0.5 0.4 1.3 1.8 1.7 1.7 2.3I‐Bankers ‐0.9 0.4 1.1 1.3 1.6 1.9 2.0
‐0.9
0.4
1.11.3
1.61.9 2.0
‐1.5
‐1.0
‐0.5
0.0
0.5
1.0
1.5
2.0
2.5
Score (‐3
to 3)
Investment Bankers: Balance of Capital with Businesses Worthy of Financing:
Surplus or Shortage?
$1MEBITDA
$5MEBITDA
$10MEBITDA
$15MEBITDA
$25MEBITDA
$50MEBITDA
$100MEBITDA
> $100MEBITDA
PEGs ‐0.9 ‐0.6 0.1 0.3 0.5 0.6 0.7 0.7I‐Bankers ‐1.0 ‐0.6 ‐0.1 0.1 0.3 0.7 0.8 0.9
‐1.0
‐0.6
‐0.1
0.10.3
0.70.8 0.9
‐1.5
‐1.0
‐0.5
0.0
0.5
1.0
1.5
Score (‐2
to 2)
Investment Banks: Next 12-Months Transactions Forecast
Almost half (48%) report an expectation to transact between 3 and 5 businesses during the next 12 months
7% 13%
23%
20%
16%
12%7%
2%0123456more than 6
• See deal flow up sharply• Relatively flat leverage and deal multiples• Extended time / slightly increased difficulty to
sell business• Increased presence of strategic buyers• Increased margin pressure on companies• Worsening business conditions
Investment Banks: The Next 12 Months
What’s Happening with Limited Partners?
• Compared to six months ago...– Allocations to VC, Mezz, Hedge, Secondaries
down slightly– Allocation to PE up slightly– Direct investments are up– Business conditions down but expected
returns on new investment up
What about the Limited Partners (LPs)?
Limited Partners: Strategy with Best Risk and Return Trade-off?
20%19%
13%11%
7% 7% 7%6% 6%
4%
0%
5%
10%
15%
20%
25%
Industry Segments with Best Risk and Return Tradeoffs
86
48%
36% 34%30%
24%
12% 10% 10% 8%
0
0.1
0.2
0.3
0.4
0.5
0.6
Freq
uency of Respo
nse (%
)
Limited Partners’ Return Expectations on New Investments (%)
VC Directs PE ‐Buyout
PE ‐Grow
PE ‐Distr.
Second. Mezz Hedge Real
EstateFund ofFunds
Median 20.0 20.0 20.0 18.0 18.0 15.0 15.0 15.0 15.0 12.5Mean 21.0 20.4 19.3 19.4 17.4 17.4 13.1 13.1 14.3 12.5
20 20 2018 18
15 15 15 1513
0.0
5.0
10.0
15.0
20.0
25.0
Gross expected returns (%
)
Importance of Factors When Raising Funds
4.5 4.44.0
3.5 3.5 3.3 3.2
0
1
2
3
4
5
Generalpartner
Specificstrategy
Hist. Perf. allFunds
Returnedcapital frommost recentfund (DPI)
Residualvalue of
most recentfund (RVPI)
Gut feel /Instinct
Specificlocation
Impo
rtan
ce Factor (1‐5)
• Increasing allocations to alternative assets• See best domestic opportunities in
California, Texas, New England states• Allocations to various strategies relatively
flat, but direct investments up• Business conditions and expected returns
up slightly
LPs: The Next 12 Months
• Deteriorated business conditions across all segments surveyed; no significant improvements expected in next 12 months
• Starting to see early signs of leverage / valuation stagnation (and decline), accompanied with higher pricing, particularly for smaller businesses
• Extremely competitive conditions for quality large companies
• Capital intensive businesses appear to be eligible for more favorable loan pricing (ABL) and are likely to continue with extended economic weakness
Conclusions
• Expected returns on new investments declining with longer exit times; more competition
• Opportunities appear to exist for investments in smaller businesses (< $10M EBITDA); debt more available than it was six months ago in $5M EBITDA segment
• See increased opportunities for working capital funding with receivables extending, inventories building, and margins compressing
• Expected continued demand for all capital types• Invest cautiously
Conclusions (Cont’d)
34.8%
23.2%
18.3%
7.9%3.8%
12.0%
A True Win-Win…Top Policy Actions for Job Growth in 2012
According to 10,644 Small Business Owners
Increased access to capital
Tax incentives
Regulatory reform
Increased competitiveness withforeign trade partnersEducation reform
Other
Source: Pepperdine Private Capital Markets Project Fall 2011 Business Owner Survey, Pepperdine University
John K. Paglia, Ph.D., CFA, CPAAssociate Professor of Finance
Senior Researcher, Pepperdine Private Capital Markets Project
bschool.pepperdine.edu/[email protected]
Thank You!