John K. Paglia, Ph.D., CFA, CPA The State of the Middle Markets Risk Management Association May 18, 2011 John K. Paglia, Ph.D., CFA, CPA Associate Professor of Finance Senior Researcher, Pepperdine Private Capital Markets Project

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

Business Owners

What are Owners Focusing on Today?

Motivation for CAPEX Planned Over Next 12 Months

What Motivates Business Owners to Open Businesses? Motive 1 2 3 4 5 Rank Opportunity to Build Value 39% 21% 13% 11% 16% Control / Flexibility 20% 27% 26% 19% 8% Opportunities for Growth 15% 31% 18% Lifestyle 14% 25% Family Opportunities 36%

Capital Access Drives Valuations in the Middle Markets 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?

State of Financing 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

How Competitive is Access to Capital? 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

Businesses Need Capital to Grow and Build Value 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

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

Most Important Emerging Issues According to Business Owners

Overall Impressions of Capital Sources Very un-favorable Un-favorable Slightly Un-favorable Neutral Slightly Favorable Favorable Very favorable Score (-3 to 3) Bank loan 6% 5% 11% 15% 34% 22% 1.48 Asset based lender 4% 9% 21% 20% 29% 1.08 Private equity fund 12% 24% 7% 0.51 Angel investor 13% 14% 23% 0.12 Venture capital fund 10% 17% 19% 2% -0.07 Mezz Fund 35% 16% -0.12 Friends and family 18% -0.22 Factor -0.48

Slightly In-expensive 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% 11% 36% 40% 2.32 Private equity 2% 12% 18% 41% 27% 2.14 Mezzanine 16% 23% 2.02 Factor 3% 14% 19% 31% 32% 2.01 Angel investor 5% 24% 35% 15% 1.62 Asset based lender 4% 8% 33% 26% 1.25 Bank loan 6% 17% 9% 0.83 Friends and family 10% 29% -0.62

Ranking of Capital Sources Overall Rank Cost Rank (Low to High) Benefits Rank Average of Rankings Bank loan 1 2 1.3 Asset based lender 3 5 3.3 Private equity fund 7 4.0 Angel investor 4 Friends and family 6 4.7 Venture capital fund 8 5.3 Mezzanine Fund 6.3 Factor 7.0

Business Transfer Intentions (Spring 2011)

Business Transfer Timing (Spring 2011)

Capital Providers

What’s Happening in Banks 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 (Cont’d) 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 Mezz 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 PE 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 (cont’d) 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

Investment Bankers

Private Business Sales Transactions Closed in Last 6 Months

Average Number of Months to Close a Deal

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 Size Average Value $1 million EBITDA 52% $5 million EBITDA 47% $10 million EBITDA $15 million EBITDA 43% $25 million EBITDA $50 million EBITDA 36% $100 million EBITDA

Reasons for 40% of Business Sale Engagements not Transacting

Valuation Gaps for Non-Transacted Engagements

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 8.0 12.0 Mfg. 5.3 10.0 Retail 3.5 7.5 8.5 Wholesale 4.8 3.3 6.5 Distribution 4.3 4.5 Oil and Gas NA Restaurant 3.0 Healthcare 6.8 Technology 9.0 10.5 Media and Entertainment 5.5 Average 4.4 5.2 5.9 6.4

Premiums by Strategics?

Difficulty Securing Senior Debt   Very difficult Difficult Somewhat Difficult Neutral Somewhat Easy Easy 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% 19.2% 28.8% 1.9% 30.8% $25M EBITDA 6.5% 4.3% 17.4% 21.7% 19.6% 8.7% 28.2% $50M EBITDA 11.4% 5.7% 20.0% 28.6% 14.3% 22.8% $100M+ EBITDA 12.9% 3.2% 25.8% 22.6% 16.1%

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% 0.2 $15M EBITDA 4.9% 22.0% 29.3% 31.7% 12.2% $25M EBITDA 6.3% 15.6% 31.3% 18.8% 28.1% 0.5 $50M EBITDA 13.8% 10.3% 31.0% 0.6 $100M EBITDA 18.5% 11.1% 14.8% 22.2% 33.3% 0.4 > $100M EBITDA 48.1% 0.7

Top Issues Facing Privately Held Businesses (Today versus Emerging)

The Road Ahead Continued economic uncertainty Inflation and competitive pressures Increasing confidence in growth prospects Increasing demand for capital and capital availability Increasing deal multiples

Thank You! John K. Paglia, Ph.D., CFA, CPA Associate Professor of Finance Senior Researcher, Pepperdine Private Capital Markets Project bschool.pepperdine.edu/privatecapital john.paglia@pepperdine.edu