state of middle markets

The State of the Middle MarketsRisk Management Association

May 18, 2011John K. Paglia, Ph.D., CFA, CPA

Associate Professor of FinanceSenior Researcher, Pepperdine Private Capital Markets

Project

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

• The project launched in 2007• We survey 12 segments• Survey asks about firm profile, behavior, returns,

view of next 12 months• Capital providers surveyed semi-annually• Last report published in December• Next report to be released in May 2011

Pepperdine Private Capital Markets Project

Bank ($1M CF lo

an)

Bank ($10M CF lo

an)

Bank ($25M CF lo

an)

Bank ($100M CF lo

an)

ABL ($5M Lo

an)

ABL ($15M Lo

an)

ABL ($50M Lo

an)

Mezz ($1M EBITDA)

Mezz ($10M EBITDA)

Mezz ($25M EBITDA)

PEG ($1M EBITDA)

PEG ($10M EBITDA)

PEG ($50M EBITDA)

VC (Early

Stage)

VC (Later S

tage)

Angel (Startu

p)

Factor $

100K/mo.

Factor $

500K/mo.

Factor $

5M/mo.

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

110%

Pepperdine Private Cost of Capital LineExpected Returns by Capital Providers on New In-

vestmentsSpring 2011

1st Quartile Median 3rd Quartile

Gros

s Ann

ual C

ost o

f New

Bor

row

ing/

Inve

stm

ent (

%)

J. Paglia

Banks (4-6%)

ABLs(3-16%)

Mezz(15-21%)

PEGs(22-30%)

VCs(25-40%)

Angel (40-55%)

Factor (27-65%)

Business Owners

Fall 2009 Spring 2010 Fall 2010 Spring 2011 Forecast

Confi-dence

0.013 -0.177 0.181 0.36 0.44

Growth Ops

0.441 0.406 0.524 0.61 0.73

-30%

-10%

10%

30%

50%

70%

Business Owner Confidence and Growth Opportunities (Net In-

creases)

% D

iffer

entia

l

What are Owners Focusing on Today?

11.0%

55.0%7.0%

3.0%

21.0%3.0% Reducing expenses

Increasing revenues from current products / services

Finding talented people

Searching for acquisition can-didates

Expanding product / service lines

Other


Prob. of Fail-ure

0.042 0.104 -0.04 -0.03 -0.15

Net income 0.047 0.226 0.113 0.19 0.54

-10%

10%

30%

50%

Business Owner Probability of Failure and Net Income (Net Increases)%

Diff

eren

tial


Employ-ees

-0.149 -0.057 0.093 0.26 0.49

CAPEX NaN -0.089 0.032 0.14 0.42

-10%

10%

30%

50%

Employees and CAPEX (Net Increases)

% D

iffer

entia

l

31.0%

24.0%9.0%5.0%2.0%

9.0%

5.0% 15.0%

Capacity expansion

Productivity

Quality improvements

Yield improvements

Tax incentives

Acquisitions

Other

No planned capital expenditures

Motivation for CAPEX Planned Over Next 12 Months


Compet. Pres-sures

0.339 0.453 0.366 0.5 0.51

Prices of Prods/Svcs

-0.011 -0.011 0.04 0.42 0.56

Time to collect A/R

NaN NaN 0.208 0.32 0.27

-10%

10%

30%

50%

Business Owner Prices, Competition, and Collection Times (Net Increases)%

Diff

eren

tial

Motive 1 2 3 4 5 Rank

Opportunity to Build Value 39% 21% 13% 11% 16% 1

Control / Flexibility 20% 27% 26% 19% 8% 2

Opportunities for Growth 15% 26% 31% 18% 11% 3

Lifestyle 14% 15% 20% 26% 25% 4

Family Opportunities 16% 13% 14% 21% 36% 5

What Motivates Business Owners to Open Businesses?

• How much senior leverage is available and how does one qualify?

• How much junior leverage is available and how does one qualify?

• How much equity capital is available and how does one qualify?

• What happens if one doesn’t qualify?

Capital Access Drives Valuations in the Middle Markets

$1M EBITDA

$5M EBITDA

$10M EBITDA

$15M EBITDA

$25M EBITDA

$50M EBITDA

Deal Mul-tiples

4.4 5.2 5.3 5.9 6.4 7.5

Se-nior Leverage

1.25 1.4 2.5 2.5 3 3

Total Leverage

3 3 3.5 3.7 4.2 5

0.5

2.5

4.5

6.5

Median Valuation and Leverage Mul-tiples (Spring 2011)

Mul

tipl

e of

EBI

TDA

• Approximately 54% of those businesses attempting to raise capital in the last six months were unsuccessful

• Of those that were successful, approximately 59% of them secured bank loans followed by 20% who secured friends and family financing

• Just 13% raised funding from angels, venture capital and private equity combined

State of Financing

• Banks denied approximately 60% of loan applications over last six months

• Angel investors funded just one business plan of 25 reviewed

• Venture capitalists funded just one business plan of 80 reviewed

• Private equity funds invested in just one business plan out of approximately 150 reviewed

How Competitive is Access to Capital?

• Expected increase in organic revenues over the next year is approximately 20%

• Nearly 95% of business owners report having the enthusiasm to execute growth strategies

• Yet just 53% report having the necessary financial resources to successfully execute growth strategies

Businesses Need Capital to Grow and Build Value

What are Top Issues Facing Privately-Held Businesses Today According to I-Bankers?

38%

12%37%

1%

2%

4% 2% 3%

Access to capital

Government regulations and taxes

Economic uncertainty (Domestic)

Inflation

Ability to find qualified employees

International economic un-certainty

Competitiveness with foreign trade partners

Other


Capital Ac-cess

-0.259 -0.226 -0.027 0.04 0.32

-30%

-10%

10%

30%

Business Owner Access to Capital (Net Increases)

% D

iffer

entia

l

Most Important Emerging Issues According to Business Owners

14.0%

31.0%

18.0%10.0%

9.0%6.0%

5.0% 6.0% 1.0%

Access to capital


Economic uncertainty / confidence (Domes-tic)

Consumer / Business demand (spending)

Inflation


International economic uncertainty


Other

Overall Impressions of Capital Sources

Capital Source

Very un-favorable

Un-favorable

Slightly Un-favorable Neutral

Slightly Favorable Favorable

Very favorable

Score (-3 to 3)

Bank loan

6% 5% 6% 11% 15% 34% 22% 1.48

Asset based lender

4% 6% 9% 21% 20% 29% 11% 1.08

Private equity fund

6% 12% 11% 24% 20% 20% 7% 0.51

Angel investor

9% 13% 14% 23% 21% 14% 5% 0.12

Venture capital fund

10% 17% 14% 22% 19% 15% 2% -0.07

Mezz Fund

9% 14% 14% 35% 16% 11% 2% -0.12

Friends and family

19% 18% 11% 18% 10% 15% 9% -0.22

Factor 15% 19% 13% 29% 11% 9% 4% -0.48

Impressions of Costs of Capital Sources

Capital Source

Very in-expensive

In-expensive

Slightly In-expensive Neutral

Slightly Expensive Expensive

Very expensive

Score (-3 to 3)

Venture capital

1% 0% 1% 11% 11% 36% 40% 2.32

Private equity

1% 1% 2% 12% 18% 41% 27% 2.14

Mezzanine 1% 1% 1% 16% 18% 40% 23% 2.02

Factor 1% 1% 3% 14% 19% 31% 32% 2.01

Angel investor

1% 2% 5% 18% 24% 35% 15% 1.62

Asset based lender

1% 4% 8% 18% 33% 26% 11% 1.25

Bank loan

2% 6% 11% 24% 32% 17% 9% 0.83

Friends and family

10% 24% 19% 29% 10% 4% 4% -0.62

Ranking of Capital Sources

Capital SourceOverall Rank

Cost Rank(Low to High)

Benefits Rank

Average of Rankings

Bank loan 1 2 1 1.3

Asset based lender 2 3 5 3.3

Private equity fund 3 7 2 4.0

Angel investor 4 4 4 4.0

Friends and family 7 1 6 4.7

Venture capital fund 5 8 3 5.3

Mezzanine Fund 6 6 7 6.3

Factor 8 5 8 7.0

Business Transfer Intentions (Spring 2011)

53%

10.0%

7%

5%

20%1% 3%

Sale of business

Bring in financial partner (sell part)

Employee stock ownership plan (ESOP)

Management buyout (MBO)

Family transfer

Gifting

Other

Business Transfer Timing (Spring 2011)

4.0% 5.0%

32.0%

30.0%

20.0%

7.0% 2.0%In the next 12 months

Between 1 and 2 years




After 20 years

At the first opportunity when valuations improve

Capital Providers

• 37% of activity from refinancing; 17% acquisitions; 12% growth financing

• 60% of applications declined, 36% lack high-quality earnings/cash flow

• Demand for loans up, due diligence efforts increased significantly

• Leverage increased slightly

What’s Happening in Banks

• Personal guarantees and collateral requirements mandatory under $15 million

• Regulatory pressure to avoid risky loans increased, 76% report feeling increased pressure

• 60% indicate that increased pressure led to declining loans that otherwise would have been made

• 60% of applications declined, 36% lack high-quality earnings/cash flow

• Demand for loans up, due diligence efforts increased significantly

• considerably along with leverage and deal multiples

• Confidence and conditions improving

What’s Happening in Banks (Cont’d)

• 26% of investments in next 12 months in business services, 25% in manufacturing, 14% in wholesale and distribution

• Demand for investment up considerably along with leverage and deal multiples

• Confidence and conditions improving• Warrant coverage and expected returns

down slightly

What’s Happening in Mezz

• 25% of investments in next 12 months in manufacturing, 14% in business services, 14% healthcare

• Demand for investment up considerably along with leverage and deal multiples

• Confidence and conditions improving

What’s Happening in PE

• Power of LPs increasing! 30% say beneficial; 38% say detrimental

• 56% now looking at larger/smaller investments to deploy capital

• Making more minority investments; 60% indicate no change in expected returns

What’s Happening in PE (cont’d)

Investment Bankers

Private Business Sales Transactions Closed in Last 6 Months

25.0%

68.0%

5.0%1.0% 1.0% 0

1-56-1011-15>16

Average Number of Months to Close a Deal

12.1%

52.5%

15.2%

2.0%

18.2%

<6 months

7-12 months

13-18 months

19-24 months

25-30 months

31-36 months

More than 36 months

Not Applicable

Components of Closed Deals

Average Value

Seller Financing / Seller Note 54.80%

Contingent earnout 53.40%

Lowered multiple of EBITDA 54.20%

Lowered amount of equity sold 34.00%

Equity Invested to Close Deals (Financial Buyers)

Company SizeAverage Value

$1 million EBITDA 52%







Reasons for 40% of Business Sale Engagements not Transacting

Valuation gap in pric

ing

Unreasonable se

ller d

emands (non-pric

e)

Unreasonable buyer d

emands (non-pric

e)

Buyers didn't l

ike / tru

st selle

r

Seller d

idn't like / t

rust

buyers

Lack

of capita

l to finance

Economic u

ncerta

inty

Insufficie

nt cash

flow

Lack

of inform

ation / transp

arency

Business

failure

Lack

of exp

osure

Lack

of motivation

Customer c

oncentra

tion

Business

was misr

epresented

New or rece

ntly esta

blished busin

ess

No market fo

r busin

ess

Lawyers

Accountants

Other0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%27.4%

10.3%

5.7%2.0%

2.5%

12.2%

7.9%5.1%

2.4%3.0%

0.2%2.7%

2.3%

1.4%1.9%4.0%

1.5%0.6%

7.0%

Valuation Gaps for Non-Transacted Engagements

2%10% 10%

27%21%

14%

7%

3% 6%

0-5%6-10%11-15%16-20%21-25%26-30%31-40%41-50%Greater than 50%

Deal Multiples by Financial Buyers

Industry$1M

EBITDA

$5M

EBITDA

$10M

EBITDA

$15M

EBITDA

$25M

EBITDA

$50M

EBITDA

$100M

EBITDA

Service 4.0 5.0 6.0 7.0 7.0 8.0 12.0

Mfg. 4.0 5.0 6.0 5.3 6.0 7.0 10.0

Retail 3.5 5.0 6.0 7.0 6.0 7.5 8.5

Wholesale 4.8 5.3 3.3 4.0 6.5 7.0 8.0

Distribution 4.3 5.3 5.0 4.5 5.3 6.5 6.0

Oil and Gas 4.5 4.0 4.0 5.0 6.0 7.0 NA

Restaurant 3.0 3.0 3.5 4.0 6.0 6.0 NA

Healthcare 5.0 6.5 6.8 6.0 6.0 7.0 7.0

Technology 5.0 7.0 8.0 9.0 8.0 10.5 9.0

Media and

Entertainment5.5 5.5 4.0 7.0 7.0 8.0 7.5

Average 4.4 5.2 5.3 5.9 6.4 7.5 8.5

Premiums by Strategics?

34%

25%

23%

9%

3%

1%5%

NoYes, 0-10% moreYes, 11-20% moreYes, 21-30% moreYes, 31-40% moreYes, 41-50% moreYes, >50% more

Difficulty Securing Senior Debt

Very

difficultDifficult

Somewhat

DifficultNeutral

Somewhat

EasyEasy Very Easy

%

Difficult

$1M EBITDA 41.3% 27.3% 19.8% 8.3% 2.5% 0.0% 0.8% 88.4%

$5M EBITDA 12.7% 14.4% 33.9% 23.7% 10.2% 1.7% 3.4% 61.0%

$10M EBITDA 6.6% 10.5% 15.8% 25.0% 27.6% 11.8% 2.6% 32.9%

$15M EBITDA 5.8% 5.8% 19.2% 19.2% 28.8% 19.2% 1.9% 30.8%

$25M EBITDA 6.5% 4.3% 17.4% 21.7% 19.6% 21.7% 8.7% 28.2%

$50M EBITDA 11.4% 5.7% 5.7% 20.0% 28.6% 14.3% 14.3% 22.8%

$100M+ EBITDA 12.9% 6.5% 3.2% 25.8% 22.6% 12.9% 16.1% 22.6%

Balance of Capital with Opportunities Companies worthy of

financing GREATLY

exceed capital available

Companies

worthy of

financing exceed

capital available

General balance

between companies

worthy of financing

and capital available

Capital available

exceeds companies

worthy of

financing

Capital available

GREATLY exceeds

companies worthy

of financing

Score

$1M EBITDA 28.6% 37.1% 20.0% 11.4% 2.9% -0.8

$5M EBITDA 13.2% 30.9% 32.4% 17.6% 5.9% -0.3

$10M EBITDA 5.7% 17.0% 39.6% 24.5% 13.2% 0.2

$15M EBITDA 4.9% 22.0% 29.3% 31.7% 12.2% 0.2

$25M EBITDA 6.3% 15.6% 31.3% 18.8% 28.1% 0.5

$50M EBITDA 13.8% 10.3% 13.8% 31.0% 31.0% 0.6

$100M EBITDA 18.5% 11.1% 14.8% 22.2% 33.3% 0.4

> $100M EBITDA 14.8% 11.1% 14.8% 11.1% 48.1% 0.7

Top Issues Facing Privately Held Businesses (Today versus Emerging)

38%

12%

37%

1%2%

4% 2% 3% Access to capital



Inflation




Other

15%

24%

14%

15%5%

14%

10% 3%Access to capital



Inflation




Other

Today

Emerging

• Continued economic uncertainty• Inflation and competitive pressures• Increasing confidence in growth

prospects• Increasing demand for capital and

capital availability• Increasing deal multiples

The Road Ahead

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

Senior Researcher, Pepperdine Private Capital Markets Project

bschool.pepperdine.edu/[email protected]

Thank You!

mailto:[email protected]

state of middle markets

Economy & Finance

quality earningscash

asset based

private equity

venture capital

business owners

companies

business services

business plan