Pepperdine cost of capital national summit 10 18 2011

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)

• 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?



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



$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%


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



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)



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



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



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


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



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



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


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 (%)


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


John K. Paglia, Ph.D., CFA, CPAAssociate Professor of Finance

Senior Researcher, Pepperdine Private Capital Markets Project

bschool.pepperdine.edu/[email protected]

Thank You!

Pepperdine cost of capital national summit 10 18 2011

Economy & Finance

Transcript of Pepperdine cost of capital national summit 10 18 2011