How to Grow Your Business By Making Acquisitions

June 27, 2012Presented by:

Welcome• Jerry Kelsheimer

– President, Fifth Third Bank

Agenda• Anatomy of an Acquisition• Buyside Merger & Acquisition

Considerations and Market Overview• Mezzanine Capital Overview• Tax Merger & Acquisition Considerations• Q&A

Anatomy of an Acquisition

Kenneth M. Haffey, CPA, CVASkoda Minotti

Pre-Acquisition

Due Diligence

Deal Negotiation Acquisition Post-

Acquisition

Anatomy of an Acquisition

Pre-Acquisition

• Assess acquisition strategy and alternative expansion options Evaluate acquisition capacity Corporate capabilities

• Industry / market monitoring• Industrial / market segmentation analysis• Competition analysis• Assisting with debt and/or equity channels

Due Diligence

• Quality of earnings• Review of accounting policies• Unrecorded liabilities• Working capital trends• Financial reporting review• Tax diligence• IT controls review• ERISA compliance review• HR regulatory review• Develop preliminary valuation model

Pro-forma earnings and cash flow model Valuation and pricing Preliminary purchase price allocation

Deal Negotiation• Assist with negotiation • Review and consult on documentation• Purchase price adjustments• Financial and tax structuring

Acquisition

• Purchase price allocation / purchase accounting• Intangible asset valuation

Post-Acquisition

• Conduct final purchase price review• Provide full post-merger integration support• Integration plan management• Organization and operational structure design• Compensation structuring• Benefit plan audit• Technology planning

Buyside Merger & Acquisition

Considerations and Market Update

Jonathan L. Ives, CFAFifth Third Bank

Status QuoGrowth Through

AcquisitionBenefits • Perceived low risk strategy

• No significant additional resources to execute• Minimal impact on current management,

employees and community• Maintain current ownership levels and

operational control• Could result in enhanced shareholder value

over time if forecasts are met or exceeded

• Build overall critical mass / increase market position

• Capitalize on potential operating synergies• Enter market/product niches and new

geographies• Improve returns to equity holders• More sharply define strategic

direction/position Company for a future sale/liquidity event

Issues • Does not significantly mitigate fundamental strategic, financial and market risks or issues

• No growth / acceleration of value• Could erode shareholder value over time• Competitors may gain market share through

acquisition

• Exposed to execution and post-deal integration risk

• Additional leverage could restrict organic growth

• Impact on key constituents - management, employees and community

Status Quo versus Growth by Acquisitions

• Assess a large number of opportunities –What targets exist and at what prices?

• Approach targets directly with a consistent message, getting a seller to the table may take time Do not wait for an investment banker to send a book as part of an

auction.

• It is more advantageous to sell the non-financial benefits first and address the price once there is momentum. But, balance that with avoiding sellers with unrealistic price

expectations.

• Manage conversations with multiple potential targets. Shift the balance of power between the acquirer and the target. The best acquisition campaigns ensure that the deal pipeline is

always full.

Exhaustive research

Go direct(Buy wholesale

not retail)

Don’t focus on price too early

Cultivate alternatives

Characteristics of a Successful Acquisition Program

• Develop acquisition strategy and criteria and establish research parameters. Identify market segments with greatest opportunity and create detailed acquisition

criteria to focus and prioritize target research. Determine which company specific research is necessary to evaluate each target.

• Develop target universe using research to identify targets that meet the targeted criteria.

• Qualify selected targets and conduct more in-depth research on all qualified targets within the universe. Further prioritize and select a focused list of companies for approach.

Target Company List Creation and Contacting Targets

• Communicate directly with target decision-makers Highlight your company’s strengths, strategy, reasons for interest and plans for the

target. Include target company research in the message to communicate understanding of

their business.

• Continue to pursue and communicate with senior people at the target in a confidential manner. Regularly share the successes your company (new customer wins, joint ventures,

recent expansions, etc.)

Target Company List Creation and Contacting Targets (cont.)

Senior Debt

Second Lien Debt

Subordinated Debt

Preferred Stock & Common Equity (Minority Interest)

Common Stock(Majority Interest)

Mezzanine Capital, companies with EBITDA greater than $3, generally involves an equity return component.

Senior Debt – cash flow and collateral support. ABL structure may have advantages.

Layers of the Capital Structure Expressed in Terms of EBITDA Leverage

Could be done as unitranche

Alternatives include: Sale of Equity in Acquirer’s Business, Personal Capital (loan or equity) and Friends & Family (limited availability).

Layers of the Capital Structure

Revolving Credit Term LoanSecurity Ranking • Senior – secured and unsecured • Senior – secured and unsecured

Tenor • Up to 5 years • 3-5 years

Amortization • None • Customized amortization

Pricing • Libor based grid • Libor based grid

Optional Redemption

• Pre-payable at par • Pre-payable at par

Financial Covenants

• Maintenance covenants including:1) Leverage ratio;2) Fixed Charge Coverage ratio

• Maintenance covenants including:1) Leverage ratio;2) Fixed Charge Coverage ratio

Reporting Covenants

• Full quarterly and annual financial statements and covenant compliance reports

• Full quarterly and annual financial statements and covenant compliance reports

Timing • 4-6 weeks • 4-6 weeks

Acquisition Financing Alternatives –Senior Debt

Subordinated Debt Preferred EquitySecurity Ranking • Subordinated • Senior to common equity

Tenor • 7-10 years • Redeemable / Putable

Amortization • Interest only • None

Pricing • 12-14% Cash and 2-4% PIK • 10% dividend, majority can be PIK

Optional Redemption

• Varies by issue • Callable by issuer after pre-determined time, typically at premium to par

• May convert to common equity

Financial Covenants

• Maintenance covenants (typically less restrictive than bank)

• None

Reporting Covenants

• Full quarterly and annual financial statements and covenant compliance reports

• Full quarterly and annual financial statements

• Additional board seats if dividend payments are missed

Other Considerations

• N/A • Will likely require board seat• Comprehensive pre-funding due

diligence required

Timing • 12-18 weeks • 12-18 weeks

Acquisition Financing Alternatives –Mezzanine Capital

Mezzanine Traditional LBO Growth-Oriented LBO

Characteristics • Provides subordinated debt; often used to facilitate leveraged transactions

• Can also provide preferred or minority common equity

• Traditionally industry agnostic, may have geographic focus

• Funds backed by institutional investors

• Targets high-growth industries, e.g. technology, healthcare, alternative energy, etc.

Benefits • Incremental capital for MBO/LBO transactions

• Limited covenants• Less equity dilution

than control equity

• Thousands of firms represent broad investor base

• Growth focusnecessitates lower initial leverage levels

• Focus on growth, rather than cost savings

Considerations • Increases risk profile• Expensive relative to

senior debt• Warrants result in

common equity dilution

• Clearly defined investment parameters

• Higher relative leverage

• Second liquidity event required in 3 to 5 years

• Higher selectivity• May require greater

equity rollover• Structure may involve

preferred shares for investor

Acquisition Financing Alternatives –Mezzanine and Private Equity

Family Office Distressed / Special Situation

Characteristics • Private company that manages investments for a single wealthy family

• Investments in financially stressed companies

• “Rescue financing” to companies undergoing operational or financial challenges

Benefits • Operates as both limited and general partner

• Less intrusive on operations• More flexible on deal size

• Accustomed to complex accounting situations

• Offers sellers speed and certainty

Considerations • Higher selectivity• May perform poor in auction• Less urgency for exit

• Much lower valuations• Investor of last resort

Acquisition Financing Alternatives –Additional Equity Sources

U.S. Middle Market M&A Volume ($100 to $500 million)

• Source: S&P Capital IQ• Note: M&A data excludes minority purchases, tender offers, spinoffs, exchange offers, repurchases, and withdrawn deals, as well as transactions with

non disclosed values.

U.S. Lower Middle Market M&A Volume (<$100 million)

400

500

600

700

800

900

1,000

1,100

1,200

061Q

063Q

071Q

073Q

081Q

083Q

091Q

093Q

101Q

103Q

111Q

113Q

121Q

0

20

40

60

80

100

120

140

160

180

200

061Q

063Q

071Q

073Q

081Q

083Q

091Q

093Q

101Q

103Q

111Q

113Q

121Q

Historical M&A Market Volume Trends

+

Sentiment M&A Market Commentary

Financing /Leverage

M&AM&A Catalysts

Strategic Appetite

Valuation / Seller Expectations

Economic Outlook /CEO Confidence + −

Financial Sponsors +

• The U.S. M&A market show signs ofstrengthening but deal flow still limited

• Mixed economic outlook and fears over returnto recessionary conditions remain biggestobstacle to an acceleration of M&A activity

• Debt markets remain strong with greaterleverage and favorable pricing Debt/EBITDA ratios for middle market sponsor

transactions between 3-3.5x.

• Strategics are well capitalized and beginning toramp up M&A efforts to drive top line growth

• Private equity firms have hundreds of billionsof un-invested capital on hand

• Valuations can be a barrier however prices arerising as fundamentals have improved andsellers are beginning to adjust valueexpectations to normalized purchase multiples

+

+ −

M&A Drivers and Outlook

Mezzanine Capital Overview

William Weil, CPAFifth Third Securities

Bank Loan Private Public

Types of Offerings Senior Loans Senior Debt, Mezzanine & Equity Senior Debt, Mezzanine & Equity

Company Size (EBITDA) Any size $3.0 million minimum $25.0 million minimum

Minimum Deal Size None $3.0 million $100 million

Interest Rate Floating Fixed, floating & variable Fixed, floating & variable

Maturity Less than 5 years 3 to 30 years 5 to 40 years

Covenants Full PackageFewer & less restrictive than bank, but

more difficult to amendMinimal

Information Confidential Confidential Public

Providers Banks Institutional Investors Institutional Investors & Individuals

Bank Loan Private Public

Types of Offerings Senior LoansSenior Debt, Mezzanine &

Equity

Company Size (EBITDA) Any size $3.0 million minimum $25.0 million minimum

Minimum Deal Size None $3.0 million $100 million

Interest Rate Floating Fixed, floating & variable Fixed, floating & variable

Maturity Less than 5 years 3 to 30 years 5 to 40 years

Covenants Full Package Fewer & less restrictive than bank, but more difficult to amend Minimal

Information Confidential Confidential Public

Providers Banks Institutional Investors Institutional Investors & Individuals

Senior Debt, Mezzanine & Equity

• Companies looking to raise capital have three basic markets which to source such capital.

• Most middle market companies source their senior debt needs in the bank market.

Market Comparison: Bank, Private and Public Markets

• Typically takes the form of either junior secured debt, senior subordinated debt or preferred stock/junior subordinated debt.

• Mezzanine capital provides issuers with capital that increases debt capacity and strengthens the credit quality of the issuer’s senior debt.

• The primary investors in mezzanine financing are institutional investors such as insurance companies and mezzanine funds.

• The overall cost of issuance makes mezzanine the kind of capital companies “Need not Want”

Mezzanine Capital Characteristics

• Investors receive their return from the following sources: Up-front Fee Fixed Current Pay (interest/dividend) Fixed Deferred Pay (Pay-in-Kind interest/dividend) Variable Deferred Pay (equity linked upside)

• Mezzanine financing typically incorporates equity linked upside in the form of warrants, common stock, conversion features, or other equity linked upside components. However, it can be arranged with or without providing the investor with equity upside. The presence of a pay-in-kind (PIK) interest component can either reduce

or eliminate the need for equity linked upside.

Mezzanine Capital Characteristics (cont.)

• Granting a second lien on applicable assets could enhance the perceived credit quality of subordinated notes. However, a careful review of existing senior debt is necessary.

• Growth and/or intangible opportunities (synergies, market positioning, new technology or products, recapitalization as a result of declining operating results) are needed to justify the issuance of mezzanine capital.

Mezzanine Capital Characteristics (cont.)

• Under current market conditions, bank’s senior debt limit is 2.0 –3.5 times EBITDA. Issuers with limited collateral and in cyclical industries may have even tighter leverage constraints.

• By adding a layer of mezzanine debt behind the senior debt, issuers can lever, on a total debt basis, 3.0 – 4.5 times EBITDA (industry dependent).

• Many mezzanine investors are flush with cash and actively pursuing refinancing transactions. A number of insurance companies, which have limited below-investment grade appetite, are focusing on mezzanine transactions to maximize the return on their limited below-investment grade basket.

Market Assessment

• Under current market conditions, investors will require the following returns on subordinated debt, given various credit qualities:

Instrument Range of Expected Investor Return Range of Issuance ($ in millions)

Junior Secured Debt 9.0% to 15.0% $5.0 to $50.0

Senior Subordinated Debt 14.0% to 18.0% $5.0 to $75.0

Preferred Stock / Junior Sub. Debt 18.0% to 22.0% $5.0 to $50.0

Market Assessment (cont.)

• The ultimate goal of issuing mezzanine capital is to increase flexibility. As with any capital instrument, greater flexibility generally increases the cost of mezzanine capital.

• The mezzanine capital in a Company’s capital structure can serve two basic purposes: 1. Permanent Capital:

Ability to lever their balance sheet multiple times over a five to seven year period. Not concerned about reducing total debt, preserving liquidity to minimize the opportunity

cost of missing growth opportunities. For such flexibility, investors want upside as compensation for additional leverage.

Structural Considerations

• The mezzanine capital in a Company’s capital structure can serve two basic purposes: 2. Bridge Capital:

Total debt reduced within 5-7 years through either sale of equity/assets or financial performance. Purpose is to provide current liquidity until a point that it is no longer needed.

Issuer wants capital that provides current flexibility but at a lower cost, knowing that leverage will be reduced.

Investors behave like debt-holders and charge for deviations from the covenant package. Typically look for step downs in covenants to assure timely repayment. Allow for prepayment at a reasonable cost and less focused on equity upside.

Structural Considerations (cont.)

• Provide issuers with growth capital at a lower cost than subordinated debt; however, it is more restrictive.

• Allows issuer to extend senior financing. • Investors are interested in two types of issuers:

Those with excess collateral; and Those with minimal collateral that have a conservative leverage profile

(Debt to EBITDA) and strong franchise value.• Note holders are granted a second lien on the Company’s assets.• Payments of interest and principal are senior obligations of the

Company.

Mezzanine Capital: Junior Secured Debt

• Typical junior secured debt is structured with the following: A fixed rate of interest (significant portion can be in the form of PIK

notes); Matures concurrently with the longest term loan of the Company; Same covenants as bank facility; Cross defaults with bank debt; and Call protection (fixed schedule: Year 1, no-call; Year 2, 103%;

Year 3, 102%; Year 4, 101%; and par thereafter).• Investors follow the same process as that of a subordinated debt or

preferred stock investor.

Mezzanine Capital: Junior Secured Debt (cont.)

• Calculation of Investor Return (9.0% to 15.0% all-in-return): Investor Return is derived from an up-front fee, current cash pay

coupon and pay-in-kind (PIK) coupon. Typically, no equity upside is granted to investors.

• Inter-creditor terms are as follows: Pari-passu with other senior lenders in right to payment prior to a

payment default. Subordinated to other senior debt in liquidation.

Mezzanine Capital: Junior Secured Debt (cont.)

Advisor Selection

Due Diligence

Information Memorandum / Collect Confidentiality Agreements

Marketing of Transaction

Term Sheets Received / Investor Selection

Investor Due Diligence

Week 1: Authorization of Fifth Third as financial advisor.

Week 2: Fifth Third due diligence meeting.

Weeks 2-4: Preparation of Confidential Informational Memorandum by Fifth Third. Contact prospective investors and collect CA’s.

Week 4-5: Marketing of transaction commences. Information Memorandum is distributed.

Week 5: Investor Conference calls conducted

Week 6: Investor Road Show /Visits arranged. Week 7: Term sheets received. Finalize business points and select investor (typically one investor). Term sheet signed and investor due diligence commences.

Week 8 to 16: Due diligence meeting for investors, quality of earnings review and other consulting work if necessary.

App

roxi

mat

ely

14 to

18

Wee

ks

Closing Weeks 17-18: Documentation, closing and funding.

Mezzanine Placement Process (Customized to meet Issuer Concerns)

• Timing Critical Pre-acquisition Expensive

During Can be coordinated with other due

diligence Will need to submit an LOI with

financing contingency Post Limited capital available for Bridge

Financing to a Mezzanine Financing

• Investor Due Diligence Site visits Quality of earnings (acquirer and

target) Market review Legal Review

• Financial Covenant Package Considerations Similar to Bank Facilities with wider

levels Standstill period Payment blockage

• Marketing Strategy Coordination with Bank Facilities Inter-creditor issues key

• Broad vs. Narrow Marketing Confidentiality is critical Broad effort can be time consuming Test market for structure and pricing

• Issuance Costs Private Placement Agent Fee Investor Up-front Fee (part of return) Investor Counsel & Consultants Company Counsel Miscellaneous

Considerations for Issuers

• Commentary

• Last week, the middle market loan market had a solid batchof new money deals, including a pair of acquisition loans anda pair of LBO transactions. Yet, issuance volume is trailing2Q11.

• Market sentiment was more upbeat, certainly compared torecent weeks, but issuance volume remains less than 2Q11volume.

• Large MM issuance of $10.9 billion so far in 2Q12 is behind2Q11 levels by 24%. Traditional MM volume trails by 43%.

• Even though, supply is still lackluster, selectivity is seen inthe market as a few deals have been passed over. In factmiddle market yields widened to the 7.7% context in June,after dropping below 7.0% in April.

• Premiums between middle market and large corporate B-rated credits declines in the second quarter of 2012.

• Average Debt Multiples of MM Loans

4.4x4.8x

4.5x4.2x 4.1x

4.5x 4.6x

4.0x 3.8x 3.9x4.1x 4.2x 4.0x

0.0x

1.0x

2.0x

3.0x

4.0x

5.0x

6.0x

FLD/EBITDA SLD/EBITDA Sub Debt/EBITDA

Senior Debt Market Update - Middle Market

• Note: Non-sponsored issuance data as of June 6, 2012. Other data as of June 14, 2012. • Source: Thomson Reuters LPC, S&P LCD

• MM Non-Sponsored Issuance: Large & Traditional • Average New-Issue First-Lien Stats (last 90 days)

Spread (L+) Floor (bps) Offer Price YTM

Middle Market 587 137 98.40% 7.80%

Large Corporate (All) 485 129 98.50% 6.66%

Gap (bps) 101 7 10 114

Middle Market 587 137 98.40% 7.80%

Large Corporate (Single-B) 497 131 98.60% 6.77%

Gap (bps) 90 6 14 103

$0

$5

$10

$15

$20

$25

$30

$35

$40

2Q06 4Q06 2Q07 4Q07 2Q08 4Q08 2Q09 4Q09 2Q10 4Q10 2Q11 4Q11 2Q12

Traditional Large

$ in billions

Senior Debt Market Update –Middle Market (cont.)

• Asset-based lending got off to a slow start in 2012,gaining momentum several weeks into 1Q12. Over 50%of the $19.1 billion in asset-based volume syndicatedduring the quarter was raised in March alone.

• New deal flow was limited at a thin 17% of total issuance,given the absence of M&A. Unsurprisingly, this gave riseto intensified competition and looser terms. Fixed assetsincreasingly crept into deal structures as spreads drifteddown modestly to what many believe to be a marketbottom.

• Lenders noted that while deals became more aggressiveby several measures, they were also far more likely to bescrutinized by credit committees. Ultimately, drawnspreads on asset-based credits remained fairly stablecompared to last quarter, closing out Q1 2012 at roughlyLIBOR + 228.

0

20

40

60

80

100

120

140

$0

$5

$10

$15

$20

$25

$30

$35

1Q06 1Q07 1Q08 1Q09 1Q10 1Q11 1Q12

ABL Volume Deal Count

• Commentary • Total ABL Volume and Deal Count ($ billions)

Senior Debt Market Update – Asset-Based

• Source: S&P LCD, Thomson Reuters LPC • Note: All data as of March 31, 2012.

050

100150200250300350400450500

1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 1Q11 1Q12

Drawn

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

2004 2005 2006 2007 2008 2009 2010 2011 1Q12

Refinancings as % of Total

• Average ABL Pro Rata Pricing (bps) • ABL Refinancings as Percentage of Total ABL Issuance

Senior Debt Market Update –Asset-Based (cont.)

Tax Merger & Acquisition Considerations

Patrick O. Mullin, CPA, CMASkoda Minotti

• Taxable Stock Deal • Taxable Asset Deal• Tax-Free Exchanges • Planning Opportunities• Due Diligence• Other Items

Agenda

P purchases all of T’s stock for cash and/or notes

Taxable Purchase of Stock

• In a taxable stock purchase, T’s shareholders recognize the gain or loss (usually capital) realized on the sale of their T stock.

• P’s basis in the T stock is equal to the purchase price paid by P plus expenses (such as legal fees) of effectuating the acquisition.

• T recognizes no gain or loss on the sale of its stock, and T's basis in its assets after the acquisition remains the same as before the acquisition (absent an election under Code §338).

• T’s other tax attributes are generally not affected by the acquisition (absent a Code §338 election).

• T's ability thereafter to use its Net Operating Loss, Capital Loss and tax credit carry forwards may be limited.

Taxable Purchase of Stock (cont.)

Advantages• Legal liability for seller• Old shareholders get capital gain treatment• Carryover tax attributes• Available with any transaction• No special tax compliance required

Disadvantages• Legal liability for purchaser• No step-up in basis• Tax attributes can be limited

Stock Sale Advantages & Disadvantages

P purchases all of T’s assets (and generally inherits T‘s liabilities) for cash and/or P notes.

Taxable Purchase of Assets

• In a taxable asset purchase, P takes a basis in T’s assets equal to the purchase price paid by P plus any T liabilities transferred to P plus P's acquisition expenses (such as legal fees).

• All of T’s assets normally generate deductions (depreciation, amortization, cost of goods sold, and the like).

• T recognizes full gain or loss on the sale of its assets.• T’s tax attributes e.g., Net Operating Loss, other carryovers and

tax accounting methods are not acquired by P.

Taxable Purchase of Assets (cont.)

• T's NOLs and other carryovers are, however, generally usable by T to offset gain on the asset sale.

• T’s shareholders do not realize taxable gain or loss on T's asset sale, unless T liquidates (except that where T is an S-Corporation.

• There is generally double tax where T sells its assets and distributes the proceeds to its shareholders in liquidation.

Taxable Purchase of Assets (cont.)

Advantages • Limited or no legal liability for purchaser• New owners get asset basis step-up for purchase price• Tax attributes are retained by seller

Disadvantages• Legal liability for seller • Purchaser does not get tax attributes• Seller may have some ordinary gain• Compliance requirements (Form 8594 - Asset Allocation Statement)

Asset Sale Advantages & Disadvantages

“A” reorganization

Tax Free Exchanges

• Internal Revenue Code Section 338(g) election (not very common) “Old” target company deemed to have sold all its assets – offset with

Net Operating Losses? “New” target company deemed to have acquired all of the assets the

next day = step up in basis for larger depreciation and amortization purposes.

Does not affect the purchasing company’s basis in target company. Purchasing company alone makes the 338(g) election.

Planning Opportunities

• Internal Revenue Code Section 338(h)(10) election (much more common) Stock sale treated as an asset sale. Advantageous if seller has gain on target company stock and gain on

its’ assets. Preserves target company’s tax attributes (Net Operating Loss?) for the

benefit of the seller. Buyer gets step up in basis for larger depreciation and amortization

purposes. Election jointly made by buyer and seller.

Planning Opportunities (cont.)

• Income Tax – Federal, State and Local• Franchise Tax• Employment/Payroll Tax• Sales & Use Tax• Property Tax• Foreign withholding & reporting• Unclaimed Funds

Due Diligence

• Financing Costs - deductible over the term of the financing• Deal Costs:

Generally, costs to acquire are required to be capitalized – facilitative? Some may be amortizable and others may attach to basis in stock of

acquired company. Nature of the cost and timing often the difference between deductibility

and capitalization – general M&A exploratory cots? Pre or Post LOI? Integration Costs?

Success based fees safe harbor – 70% non-facilitative and deductible, 30% facilitative and capitalized.

Other Items

Questions?• Gregory J. Skoda, CPA

– Chairman, Skoda Minotti

Contact Information• Kenneth M. Haffey, CPA, CVA

– khaffey@skodaminotti.com; 440.449.6800• Jonathan L. Ives, CFA

– Jonathan.Ives@53.com; 216.274.5045• William Weil, CPA

– Bill.Weil@53.com; 216.274.5992• Patrick O. Mullin, CPA, CMA

– pmullin@skodaminotti.com; 440.449.6800