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Timothy R. Lee, ASA Birmingham Estate Planning Council » September 3, 2009 Buy-Sell Agreements Convergence of Business Succession & Shareholder Planning

Buy-Sell Agreements :: Convergence of Business Succession & Shareholder Planning

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This fall 2009 presentation discussed valuation issues in buy-sell agreements as well as how the economic downturn impacted business value.

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Page 1: Buy-Sell Agreements :: Convergence of Business Succession & Shareholder Planning

Timothy R. Lee, ASA Birmingham Estate Planning Council » September 3, 2009

Buy-Sell AgreementsConvergence of Business Succession & Shareholder Planning

Page 2: Buy-Sell Agreements :: Convergence of Business Succession & Shareholder Planning

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© Mercer Capital 2009 2

Who We Are

MERCER CAPITALAmong the largest business valuation offices in the

nation and the largest in the Southeast serving a

national and international clientele

MERCER CAPITAL INVESTMENT BANKINGM&A and transaction advisory services for buyers and sellers,

focusing on mid-market corporate development and divesture

activities, reorganizations, fairness opinions, and

strategic alternatives assessment

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© Mercer Capital 2009 3

Overview of Services

» Valuation• Tax compliance • Employee Stock Ownership Plan

valuation• Corporate valuation services

» Transaction advisory services• Fairness and solvency opinions• Buy-sell agreements and private

company transactions

» Litigation support and expert testimony

• Business Damages• Shareholder Disputes• Divorce

» Public and private company financial reporting

• Purchase Price Allocation• Impairment Testing Services• Alternative Investment Portfolio

Valuation Services

» M&A and investment banking

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© Mercer Capital 2009 4

Economic Review – History

NBER Business Cycle Reference Dates (1929 - Present)

Month & Year of Economic Duration in Months ofPeak Trough Prior Expansion Contraction

August 1929 March 1933 21 43May 1937 June 1938 50 13

February 1945 October 1945 80 8November 1948 October 1949 37 11

July 1953 May 1954 45 10August 1957 April 1958 39 8

April 1960 February 1961 24 10December 1969 November 1970 106 11November 1973 March 1975 36 16

January 1980 July 1980 58 6July 1981 November 1982 12 16July 1990 March 1991 92 8

March 2001 November 2001 120 8December 2007 ? 73 > 20

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© Mercer Capital 2009 5

Economic Review – Where Are We?

Percentage Annualized Growth in Real Gross Domestic Product (GDP)

-7.0%

-6.0%

-5.0%

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

'98

'99

'00

Q1'01

Q2 Q3 Q4 '01

Q1'02

Q2 Q3 Q4 '02

Q1'03

Q2 Q3 Q4 '03

Q1'04

Q2 Q3 Q4 '04

Q1'05

Q2 Q3 Q4 '05

Q1'06

Q2 Q3 Q4 '06

Q1'07

Q2 Q3 Q4 '07

Q1'08

Q2 Q3 Q4 '08

Q1'09

Q2

Annual Rates Annualized Quarterly Rates

Department of Commerce

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© Mercer Capital 2009 6

Economic Review – Where Are We?

Seasonally Adjusted Annualized Rates ofNew Housing Starts and Building Permits (Millions of Units)

0.2

0.3

0.4

0.5

0.6

0.70.8

0.9

1.0

1.1

1.2

1.3

1.4

1.5

1.6

1.7

1.81.9

2.0

2.1

2.2

2.3

2.4

Private Housing Starts Single Family Starts Private Building Permits Single Family Building Permits

Bureau of the Census Note: Permits at a given date are generally a leading indicator of future starts. Beginning w ith January 2004, building permit data reflects the change to the 20,000 place series.

Private Housing

Single Family Housing

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© Mercer Capital 2009 7

Economic Review – Where Are We?

Civilian Unemployment Rate (Per BLS)

3.0%

3.5%

4.0%

4.5%

5.0%

5.5%

6.0%

6.5%

7.0%

7.5%

8.0%

8.5%

9.0%

9.5%

10.0%

Ja

n-9

2

Ju

l-9

2

Ja

n-9

3

Ju

l-9

3

Ja

n-9

4

Ju

l-9

4

Ja

n-9

5

Ju

l-9

5

Ja

n-9

6

Ju

l-9

6

Ja

n-9

7

Ju

l-9

7

Ja

n-9

8

Ju

l-9

8

Ja

n-9

9

Ju

l-9

9

Ja

n-0

0

Ju

l-0

0

Ja

n-0

1

Ju

l-0

1

Ja

n-0

2

Ju

l-0

2

Ja

n-0

3

Ju

l-0

3

Ja

n-0

4

Ju

l-0

4

Ja

n-0

5

Ju

l-0

5

Ja

n-0

6

Ju

l-0

6

Ja

n-0

7

Ju

l-0

7

Ja

n-0

8

Ju

l-0

8

Ja

n-0

9

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© Mercer Capital 2009 8

Economic Review – Where Are We?

S&P 500 Composite IndexMonth End Index & Percent Change From Prior Month End

500

600

700

800

900

1000

1100

1200

1300

1400

1500

1600

1700

Jul-

01

Sep

-01

No

v-01

Jan

-02

Mar

-02

May

-02

Jul-

02

Sep

-02

No

v-02

Jan

-03

Mar

-03

May

-03

Jul-

03

Sep

-03

No

v-03

Jan

-04

Mar

-04

May

-04

Jul-

04

Sep

-04

No

v-04

Jan

-05

Mar

-05

May

-05

Jul-

05

Sep

-05

No

v-05

Jan

-06

Mar

-06

May

-06

Jul-

06

Sep

-06

No

v-06

Jan

-07

Mar

-07

May

-07

Jul-

07

Sep

-07

No

v-07

Jan

-08

Mar

-08

May

-08

Jul-

08

Sep

-08

No

v-08

Jan

-09

Mar

-09

May

-09

-20.0%

-17.5%

-15.0%

-12.5%

-10.0%

-7.5%

-5.0%

-2.5%

0.0%

2.5%

5.0%

7.5%

10.0%

12.5%

S&P500 Composite Monthly % Change

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Economic Review – EESA, Now ARRA

Graphics courtesy of Wikipedia.com

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Economic Review – What’s Next?

» High unemployment recovery» High inventories and weak income suggest slow recovery with limited

push from consumers» Low capacity utilization suggests significant capacity to increase output

without new capital spend and hiring» High deficits foreshadow increasing inflation in the long-run» Energy and commodity issues still loom from emerging world demand

and geopolitical instability» Taxation issues still murky» Consensus WSJ economist poll suggests +/- 1% growth in real GDP for

2009-Q3 (deceleration of bad trends, trend inversion)

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© Mercer Capital 2009 11

Valuation Issues Abound

» Valuations at the peak or trough of the business cycle are difficult

» Valuations in an environment of financial distress and unknown paradigms are even more difficult

» Some practitioners struggling with the most basic element of present value mechanics – the discount rate• Equity market returns distorting historical data• Treasury yields extraordinarily low• Increasingly difficult to support equity premiums

» Growth assessments require more scrutiny

» Financing constraints and loan-to-value ratios suggest compromised valuations for many assets and businesses

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The Segue » New Realties = Revised BSAs

» Old formulas are likely meaningless

» Old fixed price agreements are likely stale

» Multi-appraiser processes are more costly than ever and likely to lead to greater conflicts on value

» Legal and valuation professionals have more obligation than ever to bring these matters to our clients’ attention

» Client resistance to fees and challenging discussions reflect tendencies of fear and procrastination – “things will eventually get better and then we’ll fix it”

» Nobody getting younger – likelihood of trigger events rising

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Buy-Sell Agreements - Trigger Events

» Q Quits» F Fired» R Retires» D Disabled» D Dies» D Divorced

(?)» O Others

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Categories of Buy-Sell Agreements

» Cross-Purchase Agreements• Between shareholders

» Entity-Purchase Agreements• Where the entity does the purchasing

» Hybrid Agreements• Where there may be interplay between the rights of the

shareholders to purchase and those of the company

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Types of Buy-Sell Agreements

Fixed Price Agreements

Formula Agreements

Process Agreements

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Fixed Price Agreements

» Have fixed prices

• Shareholders agree on a price

• Price is written into the agreement

• Usually, parties to agreement state in the agreement that they will update the price each year

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Fixed Price Agreements - Disadvantages

» Parties seldom update the fixed prices, even over periods of many years• Real life examples abound

» Inequities are almost certainly a result of out-of-date fixed price agreements• Real life examples abound

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Formula Agreements

» State a single formula to be applied to balance sheet and/or income statement metrics

» Examples• Multiple of EBITDA • Multiple of Pre-tax Income• Book Value• Multiple of Book Value

» No formula can withstand changes in circumstances• Valuation metrics can change with time• Non-recurring items• Often too backward-looking

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Types of Process Agreements

Multiple Appraiser

Agreements

Single Appraiser

Agreements

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Multiple Appraiser Agreements

Advantages

1. Provide a defined structure

2. All parties know, at least generally, what the process will be in advance

3. Fairly commonly known and generally understood by attorneys (who know the problems with fixed price and formula agreements)

4. Illusory Benefit – False sense that “my appraiser” will protect “my interests”

Disadvantages

1. Price not determined now

2. Potential for dissatisfaction with the process for all parties

3. Danger of advocacy

4. Uncertainty over what happens at trigger event

5. Uncertainty over final price if the process is invoked

6. Problems with any other aspect of the operation of the agreements are deferred until a trigger event

7. Expensive

8. Time-consuming

9. Distracting for management

10. Potentially devastating for affected shareholders and their families

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Advantages

1. Selected appraiser viewed as independent2. Appraiser’s valuation process is seen by all parties at the outset3. Appraiser’s conclusion is known at outset and has established a baseline price for

the agreement4. Because process is observed at the outset, all parties know what will happen when

trigger event occurs5. Because the appraiser must interpret the “words on the pages” in conducting the

initial appraisal, any issues regarding lack of clarity of valuation-defining terms will be resolved

6. Selected appraiser must maintain independence with respect to process and render future valuations consistent with terms of agreement and with prior reports

Single Appraiser Agreements Select Now & Value Now

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Advantages (continued)

7. Subsequent appraisals, either annually or at trigger events, should be less time-consuming and expensive than other alternatives

8. Parties should gain confidence in the process

9. Parties will always know the current value for the buy-sell agreement (helpful for planning all-around)

10. Appraisers’ knowledge of the company and its industry will grow over time, enhancing confidence for all parties with the process

11. Creates a means of maintaining pricing for other transactions, thereby enhancing “the market” for a company’s shares

Single Appraiser Agreements Select Now & Value Now

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Single Appraiser Agreements Disadvantages

Disadvantages

Single Appraiser – Select & Value at Trigger Event

Single Appraiser – Select Now & Value at Trigger

Event

Single Appraiser – Select Now, Value Now

1. Price not determined now x x

2. Potential for dissatisfaction with the process for all parties x x Minimized

3. Danger of advocacy x Minimized Minimized

4. Uncertainty over what will happen when a trigger event occurs x x Minimized

5. Uncertainty over final price if the process is invoked x x Minimized

6. Problems or issues with definition of value, qualifications of appraisers, or any other aspects of the operation of the agreements are deferred until a trigger event – when the interests of the parties are adverse

x x Minimized

7. Expensive

8. Time-consuming

9. Distracting for management

10. Potentially devastating for affected shareholders and their families

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Six Defining Elements of a Process Agreement

Standard of Value

Level of Value

“As of” Date

Appraiser Qualifications

Appraisal Standards

Funding Mechanism

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1. Standard of Value

• Normally fair market value

• “The value” is not operative

Six Defining Elements of a Process Agreement

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2. Level of Value

• Which level, specifically?

• Second source of confusion

• The value of my business is often control

Six Defining Elements of a Process Agreement

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Six Defining Elements of a Process Agreement

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Price we hope to get if we sell the company together

Price the rest of us can reasonably pay if we have to buy out someone else

“Fair market value of the (minority) interest”

Six Defining Elements of a Process Agreement

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$100 Per Share$100 Per Share

$60 Per Share

$140 Per Share

Six Defining Elements of a Process Agreement

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3. The “as of” Date of the Appraisal

Defines the situation at the Company, within the Industry and National Economy, and the pricing from guideline companies and comparable transactions

4. Appraiser Qualifications ■ Credentials ■ Industry experience■ Experience in appraisal ■ Reputation

5. Appraisal standards to be followed ■ ASA Business Valuation Standards■ Principals of Appraisal Practice and Code of Ethics of the ASA■ Uniform Standards of Professional Appraisal Practice

Six Defining Elements of a Process Agreement

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» Who buys?• Other shareholders• Company• Other shareholders and/or company

» Life insurance

» Adequacy of funding

» Nature of mechanism

• Cash (is there a sinking fund?)• Notes

» Down payment» Terms» Interest rate» Security

What does your client’s buy-sell agreement say about the treatment of life insurance proceeds in the event of the death of

a shareholder subject to it?

Six Defining Elements of a Process Agreement

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Harry Proceeds are a Funding Vehicle Company (Estate) Sam

1 Stock Ownership (Shares) 100.0 50.0 50.02 Stock Ownership (%) 100.0% 50.0% 50.0%3 Pre and Post Life Insurance Value ($m) $10,000.0 $5,000.0 $5,000.04 Life Insurance Proceeds $6,000.05 Repurchase Liability ($5,000.0)6 Post-Life-Insurance Value $11,000.0

7 Repurchase Stock ($5,000.0) $5,000.08 Retire / Give Up Stock (50.0) (50.0)9 Remaining Stock 50.0 0.0 50.0

10 New Stock Ownership (%) 100.0% 0.0% 100.0%11 Post-Life Insurance Value of Co. $11,000.0 $0.0 $11,000.012 Post Life Insurance Proceeds $5,000.013 Net Change in Value from Repurchase $1,000.0

Harry Proceeds are a Corporate Asset Company (Estate) Sam

1 Stock Ownership (Shares) 100.0 50.0 50.02 Stock Ownership (%) 100.0% 50.0% 50.0%3 Pre-Life Insurance Value ($m) $10,000.0 $5,000.0 $5,000.04 Life Insurance Proceeds ($m) $6,000.0 $3,000.0 $3,000.05 Post-Life Insurance Value ($m) $16,000.0 $8,000.0 $8,000.06 Repurchase Liability ($8,000.0)7 Post-Life-Insurance Value $8,000.0

8 Repurchase Stock ($8,000.0) $8,000.09 Retire / Give Up Stock (50.0) (50.0)

10 Remaining Stock 50.0 0.0 50.011 New Stock Ownership (%) 100.0% 0.0% 100.0%12 Post-Life Insurance Value of Co. $8,000.0 $0.0 $8,000.013 Post Life Insurance Proceeds $8,000.014 Net Change in Value from Repurchase ($2,000.0)

Proceeds are a Funding VehicleProceeds are a Corporate Asset

Six Defining Elements of a Process Agreement

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Buy-Sell Agreement Legal & Valuation AuditTM

» Review the buy-sell agreement from a legal and business perspective (attorneys and owners)• Based on the business today, does the buy-sell agreement say what

it should say (clients may resist talking about the issues, but it is critical that they do so before interests are adverse?

• Do the trigger events reflect the business reality of today?• Do all parties to the agreement understand how the agreement will

operate?• Determine appraisal issues in advance• Are the valuation terms clear and applicable in light of current

terminology?

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Buy-Sell Agreement Legal & Valuation AuditTM

» Review the buy-sell agreement from a valuation perspective (appraisers)

• Are the five key defining elements of a buy-sell valuation present?

• What do the “words on the page” say to an appraiser about the kind of value per the agreement?

• Explain how the agreement would operate from a valuation perspective

• Is there a current value for the buy-sell agreement?

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Helpful Resources

» Mercer Capital resources • www.mercercapital.com

» Uniform Standards of Professional Appraisal Practice (USPAP)

• www.appraisalfoundation.org/uspap

» American Society of Appraisers (ASA)• www.appraisers.org

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Other Resources

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MERCER CAPTIAL5860 Ridgeway Center Parkway, Suite 400 • Memphis, TN 38120

901.685.2120 (P) • 901.685.2199 (F)www.mercercapital.com

Z. Christopher Mercer, ASA, CFA

[email protected]

Andrew K. Gibbs, CFA, CPA/ABV

[email protected]

James E. Graves, ASA, [email protected]

Timothy R. Lee, [email protected]

Travis W. Harms, CFA, CPA/[email protected]

Jean E. Harris, [email protected]

Questions?Matthew R. Crow, ASA, [email protected]

Wendy S. Ingalls, CPA/ABV, CBA, ASA

[email protected]

Nicholas J. [email protected]

For further information, feel free to contact any of our senior professionals listed below:

Page 38: Buy-Sell Agreements :: Convergence of Business Succession & Shareholder Planning

Mercer Capital’s M&A Overview2nd Quarter, 2009

Prepared byTimothy R. Lee, ASA & Nicholas J. Heinz, ASA

901.685.2120

MERCER CAPITAL www.mercercapital.com

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M&A Deal Volume

» Transaction volume declined in 2008 and has weakened further in 2009

M&A Activity

0

2,000

4,000

6,000

8,000

10,000

12,000

2003 2004 2005 2006 2007 2008 LTM

$0

$200

$400

$600

$800

$1,000

$1,200

$1,400

Number of Deals Value of Deals ($billions)

2003 - Present

Source: Mergerstat, Flashwire US Monthly.

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M&A Middle Market Deal Volume

» Middle market activity has followed that of the broader market

Number of Middle Market Deals

0

500

1000

1500

2000

2500

3000

Q2 2007 Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008 Q4 2008 Q1 2009 Q2 2009

Source: Mergerstat; Includes deals valued at between $1 million to $500 million, plus undisclosed deals .

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M&A Transaction Types

» Approximately 50% of all deals involve privately owned sellers

Components of M&A Activity - Transaction Type

0%

20%

40%

60%

80%

100%

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Divestures Publically Traded Sellers

Privately Owned Sellers Foreign Sellers

Source: Mergerstat Review

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M&A Transaction Size

» Most deals are below $100 million (approx. 80%)

Components of M&A Activity - Transaction Size

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Under $5 million $5 million - $25 million$25 million - $100 million $100 million - $500 million$500 million - $1.0 billion Over $1.0 billion

Source: Mergerstat Review

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M&A Pricing Report

» Not surprisingly, P/E multiples were low in 2008

Price/Earning Multiples

0

5

10

15

20

25

30

35

2002 2003 2004 2005 2006 2007 2008

Average P/E Offered Median P/E Offered

Source: Mergerstat; Excludes negative P /E multiples and P /E multiples greater than 100.

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M&A Pricing Report

» Average P/E multiples showed some recovery during first Q1 2009

Average P/E

0

5

10

15

20

25

30

35

Q2 2007 Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008 Q4 2008 Q1 2009 Q2 2009

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M&A Pricing Report

» The disparity in multiples was large in 2008 across deal sizes Size clearly matters in deal pricing

Median P/E Offered

0

5

10

15

20

25

30

2002 2003 2004 2005 2006 2007 2008

$25 million or less $25 million - $50 million $50 million - $99.9 million Over $100 million

Source: Mergerstat; Excludes negative P /E multiples and P /E multiples greater than 100.

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M&A Middle Market Pricing Report

» Middle-market multiples remain low compared to 2007 and 2008 but have increased relative to Q1 2009

Average EV/EBITDA for Middle Market Deals

0

2

4

6

8

10

12

14

Q2 2007 Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008 Q4 2008 Q1 2009 Q2 2009

Source: Mergerstat; Includes deals valued at between $1 million to $500 million, plus undisclosed deals .

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Private Equity Overview

» Private equity firms are still experiencing difficulty • The number of PE deals in the last twelve months is down 43%

from the prior year• The average P/E on a private equity deal was 17.8, whereas

strategic buyers were able to pay an average P/E of 22.2 • Credit markets remain tight • The capital raising environment is still difficult for private equity

Source: Merger Stat Flashwire Monthly.

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M&A Market Summary

» Deal volume remains low but some strategic buyers are finding attractive pricing

» Debt markets continue to hobble private equity

» Privately owned sellers continue to produce a considerable portion of the deal activity

» Smaller deals are transacting at particularly low prices on a multiples basis

» Middle market volumes and multiples have shown some signs of recovery in the last quarter – still a long way to go

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