state of the middle market today 10.25.10
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Professor John Paglia, lead researcher for the Pepperdine Private Capital Market Project, spoke at the annual meeting of the National Association of Small Business Investment Companies (NASBIC) in Palm Beach, Florida. He addressed the National Summit for Lower Middle Market Funds, the premier networking event for lower middle market private equity funds, independent sponsors, investors and service providers. http://bschool.pepperdine.edu/privatecapitalTRANSCRIPT
The State of the Middle Market TodayyNational Summit for Middle Market Funds
October 25, 2010John K Paglia Senior ResearcherJohn K. Paglia, Senior Researcher,
Denney Academic Chair, and Associate Professor of Finance
Agenda• Overview of Pepperdine Private Capital Markets
Project• Insights from Various Segments• Insights from Various Segments
– Banks– Mezzanine– Private Equityq y
• The Road Ahead: 12 Month Outlook• Panel Discussion
– Tom Hiatt, Centerfield Capital Partnerso att, Ce te e d Cap ta a t e s– Preston Walsh, PNC Mezzanine Capital– Rob Zielinski, Riordan, Lewis & Haden Equity Partners– Greg Greenburg, Altus Capital Partners
• Questions and Answers
• What is cost of capital for privately-held businesses?
Pepperdine Private Capital Markets Projectp p y
• Project launched in 2007; first semi-annual report published in July 2009
• Survey 12 segments including limited partners, privately-held business owners, capital providers, intermediaries, and appraisers
• Typical survey asks about firm profile, behavior, historical returns expected returns view of next 12 monthsreturns, expected returns, view of next 12 months
• Capital providers last surveyed in September 2010. Report to be available mid-November at http://bschool.pepperdine.edu/privatecapitalp p pp p p
How Are Investments Evaluated in the
90.0%
100.0%85%
82%89% 93%
Private Markets?
50 0%
60.0%
70.0%
80.0% 76%
49%
66%
20.0%
30.0%
40.0%
50.0%
15% 21%
11%
0.0%
10.0%
Payback Internal Rate of Return (IRR)
Discounted Cash Flow (DCF)
Multiple Analysis
Market Analysis
Option Analysis
Decision trees Simulation Analysis (i.e., Monte Carlo
Scenario Analysis
Gut feel
(IRR) (DCF) Monte Carlo methods)Angel VC PE Mezz Business Average
Source: Pepperdine Private Capital Markets Project Survey Report, February 2010
Factors(39‐75%)
VCs(25‐40%)
Angels(30‐60%)
Banks ABLs (4‐18%)
Mezz(18‐22%)
PEGs(20‐30%)
(3‐6%)( )
Banks: Today vs 6 Months Ago• No increase in business confidence/conditions
Banks: Today vs. 6-Months Ago
• Demand for loans up but increases in underwriting standards and covenant tightness
• Slight decline in standard advance rates and increased• Slight decline in standard advance rates and increased focus on collateral as backup means of payment
• Increases in senior and total leverage multiples
Banks: Loan Sizes and Motivations35%
34.9% 34.9%
Largest concentrations of
10%15%20%25%30%35%
14.3%
27.0% 27.0%
19.0%14.3%
Largest concentrations of loan sizes were between $1 million and $50 million
38 1%12.2%
2.5% Refinancing
Management buy‐out
0%5%10%
< $1M $1M ‐$5M
$5M ‐$10M
$10M ‐$25M
$25M ‐$50M
$50M ‐$100M
$100M ‐$500M
> $500M
1.6%
38.1%
10.0%14.7%
1.1%
14.7%Financing growth
Chapter 11 workout
Acquisition loan
Debtor‐in‐possession
Working capital fluctuations
Refinancing accounted for nearly 40% of all lending activity followed by acquisitions (15%)
4.3%2.4%
g p
Equipment or building
Other
by acquisitions (15%)
Banks: Senior Leverage MultiplesBusiness Services 1st Quartile Median 3rd Quartile$1M 1.2 1.2 1.9$5M 2.5 2.5 3.0
Approximately 1.2X –2.5X under $10M in
$10M 2.5 2.5 3.0$25M 2.5 3.0 3.0$50M 2.6 3.0 3.0$100M 3.1 3.3 3.4
EBITDA; 3X and above greater than $10M
Manufacturing 1st Quartile Median 3rd Quartile$1M 1.3 1.3 2.0$5M 2.1 2.5 3.0$10M 2 4 2 5 3 0
Approximately 1.3X –2.5X under $10M in EBITDA 3X and above$10M 2.4 2.5 3.0
$25M 2.6 3.0 3.0$50M 2.5 3.0 3.0$100M 2.3 3.0 3.2
EBITDA; 3X and above greater than $10M
Generally about ½ turn higher except in $1M (down from 1 5)Generally about ½ turn higher except in $1M (down from 1.5)
Banks: All in Rates on Cash Flow LoansCash flow loan all‐in‐Rate (%)
$1 million1st Quartile 5.4 Median 6.5 3rd Quartile 7 1
Median all‐in‐rates from 5% to 6.5% depending on size;
3rd Quartile 7.1 $5 million
1st Quartile 5.0 Median 5.5 3rd Quartile 6.0
$10 illi
some as low as 3.5%
Rates correspond to loan terms of 36 months (median)$10 million
1st Quartile 4.5 Median 5.5 3rd Quartile 7.0
$25 million1 t Q til 3 8
terms of 36 months (median) within range of 30 – 60 months (1st and 3rd quartile)
1st Quartile 3.8 Median 5.5 3rd Quartile 7.2
$50 million1st Quartile 3.5 M di 5 0
Rates generally flat except up 50 b.p. for $1 million
Median 5.0 3rd Quartile 7.4
Banks: The Next 12 Months• Sharp increase in demand for loans
Banks: The Next 12 Months
• Underwriting standards slightly more stringent while credit quality of borrowers continues to improveimprove
• Further increases in senior/total leverage multiples• Collateral remains in focus• See confidence and conditions improving
Mezzanine: Today vs 6 Months Ago• Demand for business investment up
Mezzanine: Today vs. 6-Months Ago
• Increases in investment standards, credit quality of borrowers, appetite for risk
• Deal senior leverage and total leverage multiples up• Deal, senior leverage, and total leverage multiples up• Time to exit investments slightly longer
Mezzanine: Current ActivityNearly 70% of respondents reported making a deal in last 6 months; approximately 30% reported no t ti
30%
4%
5% 9%
2% 4% 2% 2% 01234
transactions
47.7% 53.8%
24.6%12 3%
30.0%40.0%50.0%60.0%
14%14%
14% 568101116 or more
0% 4% Refinancing
1.5%12.3% 6.2% 3.1%
0.0%10.0%20.0%
25%
21%14%
28%
7%Refinancing
Management buy‐out
Financing growth
Chapter 11 workout
Acquisition loan
Most investments in $1 million to $25 million range; Acquisition loan investments accounted for 28% of activity, followed by
14%
1%
Debtor‐in‐possession
Dividend recap
Other
refinancing (25%) and MBO (21%)
Mezzanine: Pricing
$1M $5M $10M $25M1st Q 12 4% 12 0% 12 3% 12 0%
$1M $5M $10M $25M1st Q 13 3% 12 0% 12 0% 11 8%
Sponsor Transactions Non‐Sponsor TransactionsInterest Rate (%)
1st Q 12.4% 12.0% 12.3% 12.0%Median 13.3% 12.8% 13.0% 12.0%3rd Q 13.6% 13.0% 13.0% 12.0%
1st Q 13.3% 12.0% 12.0% 11.8%Median 14.0% 14.0% 12.0% 12.0%3rd Q 14.0% 14.0% 13.0% 12.8%
PIK (%)$1M $5M $10M $25M
1st Q 3.3% 2.0% 2.0% 2.6%Median 3.5% 3.0% 2.0% 2.9%3rd Q 3.8% 4.0% 3.0% 3.0%
$1M $5M $10M $25M1st Q 2.0% 1.0% 2.0% 2.5%Median 2.0% 2.0% 2.0% 3.0%3rd Q 2.0% 2.0% 2.8% 3.0%
TotalReturns $1M $5M $10M $25M1st Q 18.0% 17.5% 17.3% 17.9%Median 20 0% 20 0% 18 9% 18 5%
TotalReturns $1M $5M $10M $25M1st Q 23.0% 22.0% 20.0% 17.8%Median 24 0% 22 0% 20 0% 18 0%
Total Returns (%)
Median 20.0% 20.0% 18.9% 18.5%3rd Q 22.0% 22.3% 20.0% 19.0%
Median 24.0% 22.0% 20.0% 18.0%3rd Q 24.5% 24.0% 21.3% 18.5%
Mezzanine: Total Leverage and Time to ExitMezzanine: Total Leverage and Time to Exit
Total Leverage Ratios (x EBITDA)
$1M $5M $10M $25M1st Q 2.9 3.5 3.5 4.4 Median 3.5 3.5 4.0 4.8 3rd Q 4.1 4.0 4.0 5.0
Represents additional 1 – 2 turns of EBITDA (after senior), increasing with size; relatively flat from 6 months ago
$25M f 4 5X
$1M $5M $10M $25M
except $25M up from 4.5X
Time to Exit (Months)$ $ $ $
1st Q 36 48 48 33 Median 48 54 60 36 3rd Q 63 60 60 42
Looking to exit in 3‐5 years
Mezzanine Investments: Next 12 Months
5%
2% 2%
11%2%
4% 2%5%
7%
4%012345
Largest concentration of responses indicate plan for four transactions in
( )29%
13%
14%567891012
next 12 months (29%); 56% are planning between four and six
6.0% 1.4%0.7%4.2% 1.4%
0.4%1.2%1.4%2.8% 6.2% Consumer services
RestaurantHealthcareLife sciences
1216 or more
Business services (25.4%), 12.2% 3.1%
2.4%
25.4%21.5%
9.1%0.8%
Life sciencesRetailReal estateBusiness servicesManufacturingWholesale and distributionFinance, insurance, and relatedInformation and technologyM di d t t i t
manufacturing (21.5%), and healthcare (12.2%) look to be areas targeted for investment; manufacturing down from 27 8% Media and entertainment
Agriculture and miningEngineering and constructionTransportationOil, gas, and other utilities
manufacturing down from 27.8%
Mezzanine: A View to the Next 12 Months
• See increases in demand for business investment credit
Mezzanine: A View to the Next 12 Months
See increases in demand for business investment, credit quality of borrowers up, increasing appetite for risk, and investment standards stabilizing
• Deal, senior leverage, total leverage multiples increasing further
• See size of industry increasing• See size of industry increasing• Sees improvement in returns Last 12
months Next 12 months
1st Quartile 7.3% 12.0%di % %Median 15.0% 18.0%
3rd Quartile 19.3% 22.0%
P i t E it T d 6 M th APrivate Equity: Today versus 6 Months Ago
• Demand for business investment is up as are investmentDemand for business investment is up, as are investment standards, appetite for risk, and quality of companies seeking investment
• Leverage and deal multiples increased; exit times longer• Increased ability to assess and price risk• General contraction in size of industry• General contraction in size of industry• Communication with and power of LPs has increased
Private Equity: Current Activity
32.7%6.1%3.4%
3.4%1.4%0.7%
0.7%1.4%
2.0%0.7%1.4% 0
1
2
3Nearly 68% of respondents reported making a d l i l t 6 th i t l 33%
21.1%
25.2%
4
5
6
7
8
deal in last 6 months; approximately 33% reported no transactions
9
10
12
16 or more
50 0% 43.5%
10 0%
20.0%
30.0%
40.0%
50.0%
3 1%
25.9%30.6%
43.5%
31.6%
21.8%
10.4%4.7%
The largest concentration of checks written was in the $10 ‐ $25 million range (43.5%) followed by $25 ‐ $50 million (31.6%) and $5 ‐ $10 million
0.0%
10.0%
< $1M $1M ‐$5M
$5M ‐$10M
$10M ‐$25M
$25M ‐$50M
$50M ‐$100M
$100M ‐$500M
> $500M
3.1%million (31.6%) and $5 $10 million (30.6%)
Private Equity: Deal Multiples and Equity C t ib tiContributions
EBITDA 1st Median 3rd Median equityQuartile Quartile
$1M 38.8% 60.0% 82.5%$5M 40.0% 60.0% 70.0%$10M 50.0% 57.5% 61.6%
Median equity contributions reported range from a high of 60% for smaller transactions to
$25M 25.0% 47.5% 60.0%$50M 21.3% 32.5% 40.0%$100M 10.0% 20.0% 22.5%
20% for larger companies; improved > $10 million
EBITDA 1st Quartile Median 3rd QuartileQ Q
$1M 3.9 4.0 5.3
$5M 4.5 5.0 5.7
$10M 5.0 6.0 7.0
Deal multiples range from a median of 4X EBITDA to 7.5X for transactions with $50 million EBITDA $25M 5.5 6.0 7.8
$50M 7.5 7.5 8.0
EBITDA
Private Equity: Expected Returns and Exit TiTimes
EBITDA 1st Quartile Median 3rd Quartile Expected gross annual returns on $1M 25.0% 30.0% 35.0%
$5M 25.0% 30.0% 30.0%
$10M 24.5% 30.0% 31.3%
new investment range from a median of 25% for larger transactions to 30% for smaller ones
$25M 25.0% 28.0% 30.0%
$50M 22.0% 25.0% 30.0%
ones
EBITDA 1st Quartile
Median 3rd QuartileQ Q
$1M 48.0 60.0 60.0 $5M 48.0 60.0 60.0 $10M 36.0 48.0 48.0 $25M 37.0 48.0 60.0 $
Expected exit times range from 48 months for larger transactions to 60 months for smaller ones
$50M 48.0 48.0 60.0 $100M 48.0 48.0 48.0
Private Equity Investing: Next 12 Monthsq y g4%
9%4% 8%
1% 2% 1%2%1%1% 3% 0
1234
Nearly 2/3 (64%) are looking to make 2 – 4 investments in the next year and approximately 12% of those will be in distressed assets (prior was 17 9%)
Distressed as a % of total # of transactions 12.3%Distressed as a % of total VALUE of transactions 10.0%
30%
23%
11% 5678101214
be in distressed assets (prior was 17.9%)
6.0% 1.2%
11.2% 1.8%2 2%6.2%
3.3%
1.8%0.9%
1.6%1.7% 4.6%
3.6% Consumer servicesRestaurantHealthcareLife sciencesRetailReal estate
1516 or more
Manufacturing (22.7%, from 2.2%2.3%
16.7%
22.7%6.3%
6.0%
Real estateBusiness servicesManufacturingWholesale and distributionFinance, insurance, and relatedInformation and technology Clean / green technologyMedia and entertainment
Manufacturing (22.7%, from 25.5%), business services (16.7%), and healthcare (11.2%, from 8%) appear to be the targets of nearly h lf f ll i t t Media and entertainment
Agriculture and miningEngineering and constructionTransportationOil, gas, and other utilitiesOther
half of all investments
Private Equity: A 12-Month View
• See increases in demand for business investment, standards, quality of companies seeking investment, increasing appetite q y p g g ppfor risk
• Greater ability to assess and price riskD l i l t t l l lti l i i• Deal, senior leverage, total leverage multiples increasing further
• Communication with and power of LPs increasing furtherp g• More contraction in size of PE industry• See improvement in returns Last 12
months Next 12 months
1st Quartile 18.0% 22.0%Median 25.0% 27.0%3rd Quartile 35.5% 35.0%
General Survey Insights Across All Segments• What is the #1 issue facing privately-held businesses today?
– Limited access to capital (40%)
y g g
p ( )– Government regulations (taxes, healthcare, etc.) (30%)– Economic environment / uncertainty (20%)
• What is the #1 emerging issue facing privately-held• What is the #1 emerging issue facing privately-held businesses?– Tighter government regulations (35%)
Li it d t it l (25%)– Limited access to capital (25%)– Economic environment / uncertainty (14%)
General Survey Insights: Private Equity, Mezzanine,
• What are the significant trends and developments in private
and Venture Capital
What are the significant trends and developments in private equity?– Risk aversion / stricter investing requirements (21% mezzanine, 22%
venture capital 17% private equity)venture capital, 17% private equity)– Businesses facing lower demand / increasing competition / lower
margins (21% mezzanine, 22% venture capital, 17% private equity)Government regulations (12% mezzanine 14% venture capital 17%– Government regulations (12% mezzanine, 14% venture capital, 17% private equity)
What about the Businesses?• Compared to six months ago...
– Time to collect receivables is upOwner compensation is down– Owner compensation is down
– Competitive pressures are up– CAPEX is flat, as are other expenses
Opportunities for growth are up sharply but– Opportunities for growth are up sharply, but...– Access to growth capital is down!
• Who can help? LPs say PE (48%) and Mezzanine (33%) offer best i k/ t t d ff !risk/return tradeoffs!– PE returns at 17.0%– Mezz returns at 12.1%
11%
33%48%
8%
Venture Capital
Mezzanine Investment
Private Equity48% Private Equity
Hedge Fund
The Road Ahead• Economic View
– GDP at 1.1%P b bilit f d bl di i t 35%– Probability of double-dip recession at 35%
• Industry View– Mezzanine and private equity favorite asset classes– Deal flow increasing– Leverage and deal multiples increasing
• Business View– Desperate for growth capital– Many owners still waiting to sell
Thank You!John K. Paglia
Thank You!John K. Paglia
Associate Professor of FinanceSenior Researcher Pepperdine PrivateSenior Researcher, Pepperdine Private
Capital Markets Projectbschool.pepperdine.edu/privatecapital