Commercial Lending and Equity Deal Terms for Middle Markets: Borrower and Lender Perspectives Negotiating Financial Covenants, Leverage Ratios, Equity Cures, EBITDA, IC Agreements and More

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THURSDAY, JANUARY 23, 2014

Presenting a live 90-minute webinar with interactive Q&A

Shaan R. Kapoor, Vice President, Loop Capital Markets, Chicago

Ati Khatri, Horwood Marcus & Berk, Chicago

Bryan P. Rozum, Vice President, CapX Partners, Chicago

Brian Ruger, Vice President, Wells Fargo Regional Commercial Banking Office, Chicago

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Outlook For Middle Market Deal Terms in 2014

Thursday, January 23, 2014

5

Introduction

Senior Lending

Mezzanine/Alternative Finance

Middle Market M&A

Outlook for 2014

Q & A

Overview

Introduction of Panel Members

ATI P. KHATRI concentrates his practice on all aspects of business planning for middle-

market businesses and closely-held companies, including mergers and acquisitions, commercial real estate

transactions, debt and equity financing, corporate governance, and a wide range of

other general corporate matters.

Ati's particular focus has been to provide both lender-side and borrower-side loan

documentation for banking institutions and middle market businesses to facilitate complex commercial loan transactions ranging from $5 million to $100 million. He serves as the lead

deal attorney in the negotiation and documentation of credit agreements, security

agreements, guaranties, subordination agreements and other ancillary loan

documents on behalf of banking clients and middle-market borrowers. He also represents middle market companies seeking senior and mezzanine debt financing in conjunction with

mergers and acquisition transactions in a variety of industries by negotiating purchase

transaction documents and financing documents.

Ati P. Khatri

Horwood Marcus & Berk Chartered

akhatri@hmblaw.com

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BRIAN RUGER is a Vice President and Relationship Manager for the Wells Fargo Regional Commercial Banking Office in

Chicago. Brian focuses his efforts on originating and managing middle-market client relationships by providing commercial loans,

treasury management, and deposit products to companies with annual sales of $20 million

and greater in the northern Illinois area.

Prior to joining Wells Fargo in 2008, Brian started his commercial banking career at

LaSalle Bank in 2004, where he went through the commercial banking training program.

Brian received his B.B.A. in accounting from The University of Iowa.

Brian has been a weekly volunteer at the Ann & Robert H. Lurie Children’s Hospital of

Chicago and a past Associate Board Member of the Special Children’s Charities – Special Olympics of Chicago. Brian lives in Chicago

with his wife.

Brian Ruger

Wells Fargo

Brian.M.Ruger@wellsfargo.com

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BRYAN ROZUM joined CapX Partners in August 2010 and is responsible for business development and

underwriting within the Midwestern region of the United States. Prior to joining CapX, Bryan served as a Loan Officer within the commercial lending division at The PrivateBank. Prior to that, Bryan served as a commercial loan originations analyst at Prudential

Mortgage Capital Company. Bryan earned a bachelor’s degree in Finance with honors from the University of Illinois at Urbana-Champaign and has passed the Level II CFA Exam. Bryan serves as a

Junior Board Member at Metropolitan Family Services and is actively involved with the Tax

Assistance Program at Ladder Up. Bryan Rozum

CapX Partners

brozum@capxpartners.com

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SHAAN KAPOOR is a Vice President at Loop Capital Markets in the Corporate Investment Banking

Division in Chicago. At Loop, Mr. Kapoor specializes in middle-market sell-side and buy-side

M&A advisory services for Fortune 500 corporations, private companies and private equity firms for

transactions up to $250 million. Prior to joining Loop, Mr. Kapoor was the Director of Strategic

Finance at Champion Home Builders, Inc. Prior to Champion, Mr. Kapoor was an Associate at a

boutique investment banking firm, TTK Partners, LLC. Prior to joining TTK Partners, Mr. Kapoor

worked as a Senior Tax Associate at KPMG, LLP in the Federal and State tax group. While at KPMG, Mr. Kapoor worked with a number of Fortune 500

corporations within the industrial and manufacturing sectors.

Mr. Kapoor graduated magna cum laude from the College of Business at the University of Illinois at

Urbana-Champaign with a B.S. in Finance.

Shaan Kapoor

Loop Capital

shaan.kapoor@loopcapital.com

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• What do we mean by “middle market”?

• Many conceptions of what constitutes the “middle market”, ranging from $5 million in revenues to $1 billion in revenues

• Our discussion focuses on the lower end of the middle market, anywhere from $10 million to $250 million, but with a “sweet spot” of

$50 million to $75 million

Preface

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• In the years since the beginning of the “Great Recession”, an increase in investor confidence and the stability of the middle market as a whole resulted

in an increase in availability of debt and equity capital

• For many consecutive quarters after 2011, middle market companies exhibited improvement in operating performances, and default levels dramatically

improved relative to 2008 through 2010

• Unfortunately for many middle market borrowers, however, deal volume has remained inconsistent, including throughout 2013

Introduction

13

• Putting aside the very end of 2012, when a number of middle market transactions were consummated by tax motivated middle market businesses,

deal volume in 2013 was particularly flat

• Senior lending deal volume was supported primarily by refinancings and dividend recapitalizations

• Mezzanine lending deal volume was supported primarily by traditional senior-mezzanine structured loan facilities, and therefore the lack of deal volume in

the senior lending space affected the mezzanine space

• Middle market M&A, which is a catalyst for both senior and mezzanine lending activity, remained relatively flat, even though all of the factors for

robust M&A activity seemed to have been in place

Introduction

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• Notwithstanding a somewhat stagnant 2013, middle market players on all sides seem quite optimistic that 2014 will exhibit a marked turnaround with respect

to deal activity

This optimism is supported by the fact that:

• The very end of 2013 provided a slight uptick in overall activity

• There exists a meaningful amount of junior capital flowing to the middle market

• A significant amount of SBA leverage is now available to middle market lenders/borrowers

• Mezzanine lenders and private equity players have continued to increase staffing and capital-raising activities for some time now

• Most importantly, middle market companies appear to be shifting from inorganic growth through internal efficiencies to external growth through

acquisitions and capital expenditures

Introduction

15

Senior Lending Deal Volume - Past

Pre - 2007

• There were the pre-recession “good old days” of loose structures, few questions and fewer covenants

2007 – 2008

• Banks’ problems become the clients’ problems:

• Credit quality of the banks themselves comes into question

• Commencement of interest rate floors, commitment fees, term premiums for longer maturity dates, and other costs imposed by banks.

2008 – 2010

• Client’s problems become the banks’ problems:

• Middle-market companies experience drawn-out performance issues

• Revenues drop as much as 40% in many cases.

• Banks tighten credit structures and increase pricing.

• The turmoil during these years resulted in either very strong bank-client loyalty that is still present today, or prompted a banking change.

2007 2008 2009 2010 2011 2012 TODAY

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Senior Lending Deal Volume - Present2

2007 2008 2009 2010 2011 2012 TODAY

2011 – Present

• “The Recovery”

• Can’t rebuild revenues as quickly as the good old days? Become more cost conscious!

• Bank fees and interest rates are included in company-wide cost-saving initiatives at middle-market businesses.

• The New Look of Commercial Banking Relationships

• “Cross-sell” trend has resulted in very sticky banking relationships.

• Online portals, Treasury Management, Payment/Receivable Automation, ERP Integrated solutions, etc. makes it very difficult to move banks.

• The trigger events needed to prompt a banking change are less likely to occur during a slow market recovery.

• Commercial lenders must demonstrate enough value to encourage their prospects to leave the incumbent bank.

• The most impactful “value” proposition? Unprecedented pricing… 17

Pre-2008

Even the pre-recession “good old days” weren’t as good as today’s rates

2008 – 2010

• As LIBOR falls, credits went up.

• Interest rate floors as high as 4.50% or more were not uncommon from institutions that found themselves funding their loans at lower

rates than their cost of capital.

Senior Lending Pricing - Past

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

05‐Feb 06‐Feb 07‐Feb 08‐Feb 09‐Feb 10‐Feb 11‐Feb 12‐Feb 13‐Feb

1 Month LIBOR

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2011 – Present

• There is no time like now for “cheap money”

• Credit quality of middle-market companies (and banks) has improved

• Banks are becoming more and more aggressive on pricing due to the slow lending environment and amount of deposits on hand for lending

• Average pricing for competitive deals is currently at LIBOR+1.50% to LIBOR+2.00%

• Spreads as low as LIBOR+1.00% are seen for the highest quality borrowers with strong collateral and structure. (Yes, this equates to all-in pricing of 1.16%

based on today’s 30-day LIBOR.)

As Shaan will explain, financial sponsors such as private equity firms should feel inclined to invest in middle market companies to take advantage of these historically

low financing costs

Senior Lending Pricing - Present

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Loan Covenants – Where do we come up with these things?!

• It should be a collaborative process between the bank & client

• Use historical financials and projections as the basis of covenant structuring

• Conduct a covenant sensitivity analysis (company performance and interest rate sensitivity) – share it with each other!

• Text book approach: allow for a ~20% cushion (i.e. covenant level to be 80%/120% of current calculation). Adjustments can go either way based on the credit profile and objectives.

Common covenants and why:

Senior Lending Covenants

• Fixed Charge Coverage Ratio

• Cash Flow Leverage

• Balance Sheet Leverage

• Net Worth/Tangible Net Worth

• Current Ratio

• Limitation on Distributions

• Unfinanced CAPEX, Limitationon Leases, and other “buckets”

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2008 – 2010

• Navigating the recession prompted a spike in covenant re-structuring• In the April 2009 Senior Loan Officer Opinion Survey on Bank

Lending Practices (during the heart of the recession):

• 40% of domestic respondents reported having tightened their credit standards on commercial and industrial (C&I) loans to firms of all sizes over the previous three months.

• That was the first time since January, 2008 that the proportion of banks reporting such tightening fell below 50%.

• Re-structuring covenants became the norm based on covenant violations during the recession. Step-downs, step-ups, and delayed covenant calculations were incorporated into waivers and restructuring.

Senior Lending Covenants

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2011 – Present

• Slight shift back towards “covenant-lite” packages for the strongest ofborrowers at the higher end of the middle-market.• This is less prevalent in the lower end of the middle-market.

• There is a difference between “covenant-lite” and “covenant loose”.

• Advance rates are returning to more aggressive levels sooner thancovenant levels, especially on fixed assets:

• Higher Loan-to-Values (LTV) on real estate

• More soft costs included in M&E financing

• Higher inventory advance rates with fewer ineligibles

Senior Lending Covenants

22

What can we expect for senior lending in 2014?

2014 Outlook

23

• Commonalities between mezzanine and equipment finance

• Both fulfill growth capital and liquidity needs

• Both serve as a substitute to using investor equity and/or operating cash flow

• Prevents existing equity dilution

• Allows companies to invest cash flow in other valuable projects

Benefits of Equipment Finance vs. Mezzanine: Security interest in equipment assets leads to:

• Less expensive pricing

• More flexible leverage ratios (off-balance sheet operating lease)

• More accommodating structures (100% advance on equipment value, low-high repayment schedule

Mezzanine and Equipment Finance

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• Within the alternative debt community, deal flow was consistent but not overly robust during 2013

• CapX deal proposals were up substantially from 2012

• CapX’s SBIC Fund (CapX Fund IV) started deploying capital in 2012 and actively pursued opportunities to deploy capital in 2013

• Capital sources such as the SBIC Program have allowed alternative debt funds to grow substantially

• 10-year, fixed rate debt capital; leverage commitments up to 3.0X private investor commitments

• Increased competition in the marketplace (especially on higher quality deals)

• During challenging economic conditions (2008-2011), borrowers focused mainly on: quality of lending relationship; and lender’s ability to execute and support the business going forward

• 2012/2013 timeframe has been more about pricing and structure

Summary of Deal Flow in 2013

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• Certain industries are particularly well-positioned foralternative financing relationships• Service based and asset light (healthcare, cloud based software)

• Technology focused (social networking, online retail)

• Optimistic industry projections (energy/fracking)

• Manufacturing/Distribution: But do they have the superiortechnology compared to the competitors?

• Sub $1.0M EBITDA and asset-light businesses use alternativefinancing until they become “bankable”• Unitranche facility

• Small revolver paired with Term A/Term B Facilities

Types of Borrowers Who Can Take Advantage

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• Mezzanine pricing also continues to come down, although not to the degree as senior lender pricing

• 12% to 14%, with 11% to 12% current pay and 1% to 2% paid in kind, for companies with less than $15 million EBITDA (noticeable decrease from 2012 ); and

• 11% to 13%, with 10% to 11% current pay and 1% to 2% paid in kind, for companies with more than $15 million EBITDA (noticeable decrease from 2012 )

• Warrants and equity positions as a supplement to mezzanine pricing• Warrant coverage to provide mezzanine lender with an all-in

IRR of 12% to 18% (consistent with 2012 )• The utilization of warrants in subordinated debt transactions has

steadily decreased in recent quarters

Mezzanine Debt Pricing

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Background

• Often times, intercreditor provisions are the most heavily negotiated aspect of any financing transaction

• After 2008, higher default levels throughout the middle market shined the light squarely on the rights afforded to senior and mezzanine lenders under the underlying intercreditor

agreements

• Because each intercreditor relationship is very different from one another, there is no such thing as a “market” provision in an intercreditor agreement, notwithstanding what attorneys

recite to one another in an intercreditor negotiation

• Different approaches for different lending scenarios

Intercreditor Relationships

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Typical Open Items of Negotiation

Subordination of Liens vs. Subordination of Debt

Shared Collateral vs. Collateral Carve-outs

Standstill Periods

Limitations on the Amount of Debt

Limitations on New Liens

Release of Prior Liens

Intercreditor Relationships

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What can we expect for alternative finance in

2014?

2014 Outlook

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For the full year 2013, the total number of global middle-market transactions decreased 5.7%, while disclosed dollar volume decreased 1.0% over 2012.

Global Middle-Market M&A Activity (1,2)

(1) Disclosed transactions as reported by Thompson Reuters.(2) Global middle market defined as transactions involving targets with Total Enterprise Value (“TEV”) less than $500 million.

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Average purchase price multiple in the first nine months of 2013 for transactions in the $250 million to $750 million TEV range surpassed the pre-Recession highs seen 2008, while

multiples for transactions between $50 million to $250 million and and sub-$50 million in TEV were not far from their 2006 highs. There continues to be a “size premium” in the marketplace, as transactions greater than $50 million in TEV tended to be awarded with

premium multiples.

EBITDA Multiples (1)

(1) Disclosed EBITDA multiples as reported by Dealogic through 09/30/13.32

Excluding Real Estate and Financials, the Industrials sector comprised 17.4% of announced deal value, followed by Energy & Power, Materials and Technology, representing 16.9%,

12.6% and 11.6% of the total market, respectively.

Global Middle-Market M&A Activity by Target Industry (1,2)

(1) Disclosed transactions as reported by Thompson Reuters, excluding financial and real estate industry transactions.(2) Middle market defined as transactions involving targets with TEV less than $500 million. 33

Public company acquisition activity declined to 18.7% over the last twelve months, compared with 28.5% in 2006 and nearly 47% in 2001.

US Middle-Market Merger Activity by Acquirer (1,2,3)

(1) Disclosed transactions as reported by Dealogic and research reports through 09/30/13.(2) Global middle market defined as transactions involving targets with TEV less than $750 million.(3) “LTM” defined as Last Twelve Months. 34

2013 was a robust year for private equity fundraising, as buyout funds raised an aggregate $185 billion in 2013, a 23% increase over 2012.

Private Equity Fundraising (1)

(1) Trade journals and research reports for private equity fundraising categorized by Buyout, Distressed, Fund of Funds and Secondary funds. 35

The cash and marketable securities balance for the S&P 500 (ex-Financials) grew 18.0% year-over-year to a balance of $1.36 trillion at the end Q3. Additionally, as of the end of the third

quarter of 2013, private equity firms had approximately $385 billion in dry powder.

Uninvested Capital for Buyouts (1)

(1) Source: FactSet Fundamentals via FactSet Alpha TestingTrade and Wall Street research reports for private equity funds for Buyout firms. 36

Barring any major fiscal or systematic shock to the financial markets, there are a number of reasons to expect robust M&A deal volume in 2014.

2014 Middle Market M&A Outlook

• Economical and political stability

– Confidence in the global economy is at a two-year high

– US Congress passed its first budget in four years

• Cost of capital is virtually zero

– Cost of capital continues to be at its lowest rate and should continue for the next two or three years

– Even small increases in interest rates shouldn’t have a major negative impact on M&A activity

• Valuations and EBITDA multiples for the middle market are increasing and returning to pre-recession levels for certain industries and deal types

– Improved cash flows for middle-market companies and lack of “good deals” in the marketplace, are driving valuations higher

– Sellers capitulating on overly optimistic valuation expectations37

2014 Middle Market M&A Outlook

• Abundance of “dry power” on the sidelines

– Over $1.5 trillion of cash available between large corporates and PE buyout funds

– Pressure to find deals and increase returns on idle cash will begin to outweigh the risks of putting capital to use

• Pent-up supply in the middle market

– Would-be sellers have held off on selling until valuations returned to their former levels

– Increased exit activity from PE firms

• Changing demographics

– Increasing number of baby boomers, without the next generation of family succession, will continue to sell their companies

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