Fall 2009 Survey FindingsJanuary 27, 2010

John K. Paglia, Senior Researcher,Denney Academic Chair,

and Associate Professor of Finance

• Web-based survey that included banks, asset based lenders, mezzanine funds, private equity, venture capital, and privately-held companies

• Typical survey asked about firm profile, credit box, historical returns, expected returns, view of next 12 months

• Capital providers were surveyed in October and November 2009

• Over 700 responses

Private Capital Markets Survey

Banks ABLs Mezz PEGs VCs0%

10%

20%

30%

40%

50%

6.8%

13.0%

18.5%

25.0%

38.2%

Pepperdine Private Capital Market LineCost of Capital by Financing Source

Spring 2009 Fall 2009

• Tough Credit Environment– Despite fewer applications, the time to

process loans has increased– 82% report reductions in credit quality of

borrowers– 45% report smaller loan sizes

• 64% report reductions in cash flow multiples

• 45% report declines in standard advance rates on collateral

• Industry Challenges Continue– Increases in delinquency rates (nearly

half report an increase)– Increases in charge-off rates (nearly half

report an increase)– 80% report the number of loans being

made by competitor banks declined

Banks (Senior Lenders) Loan Type Declined % Offer % Book to Offer %Cash flow 67.3% 31.7% 58.6%Collateral 63.3% 36.7% 60.4%Real estate 60.3% 39.0% 75.6%

9.2%

20.3%

16.5%

14.2%

8.2%1.6%

3.4%

3.0%

12.8%9.1%1.7%

Reasons for Declined LoansQuality of EarningsQuality of Cash FlowSize of CompanyDebt LoadInsufficient CollateralInsufficient CreditAvail of Pers. GuaranteesInsufficient Operating HistoryInsufficient Management TeamWeakening Industry Economic concernsOther

• Motivations for Loans– Refinancing at 40.2% (44%

previously)– Acquisitions at 17.1% (7%

previously)– Growth at 9.8% (12% previously)

• Important Factors when Lending– Collateral at 14.8% (7% previously)– Liquidity (14.1%)– Debt to cash flow (12.2%)– Fixed charge coverage (12.1%)

Banks (Continued)

40.2%

2.6%9.8%1.1%

17.1%0.5%

14.5%

12.8%

1.2% RefinancingManagement buy-outFinancing growthChapter 11 workoutAcquisition loanDebtor-in-possessionWorking capital fluctuationsEquipment or buildingOther

Financial Ratio 1st Quartile Median 3rd

Quartile

Fixed charge coverage 1.2 1.3 1.3

Funded debt to EBITDA 2.5 3.0 3.5

Total debt to EBITDA 3.0 3.5 4.0

Debt to tangible net worth 2.2 3.0 4.0

• Restrictive Credit Environment– 82% report increases in loan

applications– 73% report lower percentage of

borrowers approved for credit

• Industry Concerns Linger– Increases in delinquency rates– Increases in charge-off rates– Declines in the number of loans

being made by competitor banks

Asset Based Lenders Declined % Offer % Book to offer %

Receivables 69.4% 30.6% 41.9%Inventory 74.5% 25.5% 50.9%Equipment 70.7% 29.3% 54.4%Real Estate 68.6% 31.4% 47.3%

14%10%

6%

17%29%

2%0%1%2%

6%3% 10%

Reasons for Declined LoansQuality of EarningsQuality of Cash FlowSize of CompanyDebt LoadInsufficient CollateralInsufficient CreditSize/Avail of Pers GuaranteesInsufficient Operating HistoryInsufficient Management TeamWeakening Industry Economic concernsOther

• Motivations for Loans– Refinancing at 44.1% (53%

previously)– Growth at 20.2% (12%

previously)– Acquisitions at 10.4% (22%

previously)• Advance Rates

– Vary by collateral type and quality

– Highest for marketable securities and receivables

• All-in Rates Decline Significantly for Larger Loans: Working Capital

ABLs (Continued)

$0.5M $2.0M $5.0M $10.0M1st quartile 14.8% 13.3% 7.5% 5.0%Median 17.5% 14.5% 10.5% 7.0%3rd quartile 20.3% 15.0% 12.8% 12.0%

Collateral Type 1st quartile Median 3rd quartileMarketable securities 80.0% 80.0% 90.0%Accounts Receivable 80.0% 85.0% 85.0%Inventory - Low 20.0% 25.0% 30.0%Inventory - Intermediate 30.0% 40.0% 47.5%Inventory - High 40.0% 50.0% 60.0%Equipment 50.0% 50.0% 75.0%Real estate 35.0% 50.0% 60.0%

44.1%

5.1%

20.2%2.3%

10.4%

3.2%

9.6% 4.9%0.4% Refinancing

Management buy-outFinancing growthChapter 11 workoutAcquisition loanDebtor in possessionWorking capital fluctuationsEquipment or buildingOther

• Signs of Growth– Nearly 78% report increases in business plans

received– Slight net increase in number of investments

being made– 54% of respondents report growth in the size of

industry– 48% report increases in warrant coverage

• Risk Aversion– Nearly 52% report a decrease in cash flow

multiples– 56% indicate a decreased appetite for risk– 48% report an increase in interest rate spreads– Net increase in tightness of financial covenants

• Motivations for Loans– Refinancing at 31.6% (33% previously)– MBOs at 24.6% (21% previously)– Growth at 20.6% (22% previously)

Mezzanine Funds

31.6%

24.6%20.6%

1.4%

16.8%3.3% 1.8%

RefinancingManagement buy-outFinancing growthChapter 11 workoutAcquisition loanDividend recapOther

Increased Decreased SameNo. of Business Plans Rec'd

77.8% 14.8% 7.4%

No. of Investments Being Made

48.1% 33.3% 18.5%

Size of Mezzanine Industry

54.2% 16.7% 29.2%

Warrant Coverage 48.1% 11.1% 40.7%Multiple of Cash Flow

18.5% 51.9% 29.6%

Appetite for Risk 22.2% 55.6% 22.2%Interest Rate Spreads

48.1% 22.2% 29.6%

Tightness of Financial Covenants

25.9% 0.0% 74.1%

• Financial Ratios– A typical firm will invest up to 4X EBITDA

(3.75X previously)– Up to 2.5X can be senior debt (unchanged)– Minimum fixed charge ratios are 1.1X (1.2X

previously)• Pricing

– Median coupon rate of 14% (previously 13%)

– Nearly 58% with PIK provision– 65% of deals with warrants (4-8% of diluted

ownership)– Expect 8% return on warrants

• Targeting Service and Manufacturing Over Next 12 Months

Mezzanine (Continued) Ratio  Classification MedianFixed charge coverage Typical borrower 1.25  Absolute min 1.10Senior debt to EBITDA Typical borrower 2.00  Absolute max 2.50Total debt to EBITDA Typical borrower 3.50  Absolute max 4.00

Coupon Interest Rate13.0% 1st quartile14.0% Median15.0% 3rd quartile

34.0%

24.9%

1.8%1.8%

12.5%

5.0%0.1%

12.5%7.2%

ServiceManufacturingRetailWholesaleDistributionOil & GasRestaurantHealthcareOther*

• Challenging Investing Environment– 53% report a decline in leverage multiples– 62% report a decline in deal multiples– 68% report a longer time to exit deals– 70% report a decline in the size of industry

• Interesting Minority Interests– Nearly 70% of respondents report willingness to

invest in minority interests with investor protections

– Median discount from pro rata is 20%• Deal Flow Funnel

– 100 plans reviewed (up from 80)– 15 meetings– 5 term sheets– 2 letters of intent

Private EquityIncreased Decreased Same

Leverage (multiple)

17.7% 53.2% 29.0%

Deal multiples 11.7% 61.7% 26.7%Time to exit deals 68.3% 1.6% 30.2%Size of private equity industry

3.2% 69.8% 27.0%

Discount from pro rata (%)10.0% 1st quartile20.0% Median25.0% 3rd quartile

Plans Received

Meetings with

Principals

Term Sheets Issued

LOIs Signed

1st quartile 50 10 3 1Median 100 15 5 23rd quartile 200 30 10 3

• Exit Plans for Portfolio Companies– 43% report plans to sell to a public company (up

from 35%)– 30% plan to sell to another PEG (34% previously)– 7% IPO (previously 9%)

• Service and Manufacturing Industries Targeted Over Next 12 Months– Service at 30.7% (up from 27.3%)– Manufacturing at 23.8% (up from 21.3%)– Retail down to 0.8% from 4.1%

Private Equity (Continued)7%

29%

43%

1%

18% IPO

Sell to another PEG

Sell to a Public Co

Sell to a Hedge Fund

Other

30.7%

23.8%

1.4%0.8%

5.4%

8.5%0.9%

4.5%

10.8%

13.3% Service

ManufacturingRetailWholesaleDistributionOil & GasRestaurantReal EstateHealthcareOther

• Contraction Continues...– 59% report a decline in percent of plans funded

while 66% report decreasing percentages of “up” rounds

– 61% report an increase in time to exit– 73% report a decrease in appetite for risk– 61% believe fundraising prospects have declined– 91% report a contraction in size of industry

• Yet Hope Remains– Nearly 48% report increases in number of

business plans received– Approximately 46% report an increase in number

of high-quality investment prospects– 45.5% report increases in quality of portfolio

• Review 100 Business Plans to Close a Deal

Venture CapitalIncreased Decreased Same

Percent of Biz Plans Funded

4.5% 59.1% 36.4%

Percentage of "up" rounds

11.4% 65.9% 22.7%

Expected exit time

61.4% 9.1% 29.5%

Appetite for risk

6.8% 72.7% 20.5%

Fundraising prospects

14.0% 60.5% 25.6%

Size of venture capital industry

4.5% 90.9% 4.5%

Plans received 47.7% 22.7% 29.5%High quality prospects

45.5% 25.0% 29.5%

Quality of portfolio

45.5% 25.0% 29.5%

Plans Received

Meetings with

Principals

Term Sheets Issued

LOIs Signed

1st quartile 50 10 2 1

Median 100 20 2 13rd quartile 100 27.5 3 1.6

• Higher Expected Sales to TVI Ratios for New Investments Made in Last 6 Months– Stage 1 increased from 8.2X to 9.5X– Stage 3 from 6.4X to 8.5X– Stage 6 rose from 3.9X to 5.5X

• Longer Expected Time to Exit for New Investments Made in Last 6 Months– Stage 1 from 6.2 years to 7.5 years– Stage 3 from 5.1 years to 6.5 years– Stage 6 from 3.8 years to 3.5 years (shorter)

• Implied Returns on Investment Lower– Stage 1 from 40.5% to 35.8%– Stage 3 from 43.5% to 41.4%– Stage 6 from 43.3% to 43.0%

• Exit Plans– Sell to public company is 58.9% (previously

50%)– Sell to private company is 21.6% (previously

24%)– IPO is 12.4% (down from 17%)

Venture Capital (Continued)

12.4%1.0%

58.9%

21.6%

5.8% 0.2% IPOSell to another VCSell to a Public CoSell to a Private CoSell to a Hedge FundSell to Private EqOther

Sales/TVI Stage1

Stage2

Stage3

Stage4

Stage5 Stage6

1st Quartile 7.5 6.5 5.5 3.5 3.5 3.5Median 9.5 9.5 8.5 7.5 5.5 5.53rd Quartile 21.5 15.5 9.5 9.5 7.5 6.5

Returns Stage 1 Stage 2 Stage 3 Stage4 Stage 5 Stage6

1st Quartile 26.7% 26.7% 25.6% 30.0% 24.7% 19.6%Median 35.8% 35.0% 41.4% 36.3% 39.7% 43.0%3rd Quartile 53.6% 40.3% 50.6% 50.6% 46.1% 64.5%

Exit Time Stage1

Stage2

Stage3

Stage4

Stage5

Stage6

1st Quartile 6.25 5.5 5.5 4.5 3.5 2.5Median 7.5 6.5 6.5 5.5 4.5 3.53rd Quartile 8.75 8.5 7.5 6.5 6.5 6.5

• California is Target for Nearly 36% of Investments over Next 12 Months– Nearly 10.7% outside of U.S.– 5.7% in Texas– Massachusetts decline from 6.9% to

3.6%• Clean Technology is Industry

Targeted for Largest Concentration of New Investment over Next 12 Months– Increase from 12.3% to 14.5%– Software from 15.8% to 13.5%– Hardware from 6.7% to 3.2%– Biotech from 11.6% to 9.8%

Venture Capital (Continued)20.9%

13.0%

1.7%

3.6%5.7

%0.9%1.0%3.2%3.1%

8.2%1.4%

2.6%

10.7%

24.1% Northern CASouthern CACA (Other)MA TXWA StateD.C. Metro AreaNY Metro AreaNew EnglandSoutheastPhilly Metro AreaCOOutside U.S.Other*

1.8% 9.8%12.2%

2.3%

13.5%

3.2%1.8%

14.5%

0.7%3.1%

8.1%1.0%0.2%

2.9%

7.1%

8.9%9.0%

NanoBiotechMed DevicesPharmaSoftwareHardwareEnergyClean techIndustrialMedia & EnterInternet SpecificCons ProductsFinancial SvcsBusiness SvcsHealthcare SvcsInfo TechOther

• Glass Half Empty or Half Full?– Despite nearly 50% indicating increased

competitive pressures, approximately 64% report that growth opportunities increased relative to 6 months ago

– However, nearly 46% report decreased access to capital

• Businesses Report Varied Costs of Capital, Paybacks, and Expected Returns

• Realistic, Optimistic, or Delusional?– Approximately 57% believe they qualify for a

bank loan– Nearly 47% believe they qualify for a private

equity investment– Almost 41% believe they qualify for venture

capital

Privately-Held Businesses

Investments Payback Cost of Capital

Expected Returns

New computer system

2.05 10% 20%

Hiring a sales person

1.52 20% 30%

Acquire a competitor

3.22 25% 30%

Expand current market niche

2.48 20% 25%

Enter new market niche

2.77 20% 25%

0.0%10.0%20.0%30.0%40.0%50.0%60.0%

56.9%

21.8%

47.1%

10.9%

40.8%

6.3% 10.3% 12.6%

Investment Analysis Techniques Frequency of Use in the Private Markets

Payback DCF IRR Option Analysis Simulation Analysis Market Analysis Multiple Analysis Gut Feel0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

80.0%

90.0%

100.0%

57.0%

43.9%

76.4%

5.9%

31.7%

62.9%

91.1%

60.4%

Mezzanine Private Equity Venture Capital Private Businesses Average

12 Month OutlookBanks ABLs Mezz PE VC Business Average

Demand for Capital

Increase 66.7% 100.0% 74.0% 84.6% 70.5% 79.2%

Stay the same 25.0% 0.0% 22.0% 13.8% 25.0% 17.2%

Decrease 8.3% 0.0% 4.0% 1.5% 4.5% 3.7%

Capital Restrictiveness

Increase 8.3% 20.0% 4.0% 46.2% 47.7% 25.2%

Stay the same 50.0% 50.0% 74.0% 40.0% 45.5% 51.9%

Decrease 41.7% 30.0% 22.0% 13.8% 6.8% 22.9%

GDP

Overall 1.7% 1.4% 1.6% 1.0% 0.9% 0.5% 1.2%

Private Company 1.0% 1.5% 2.0% 2.1% 2.8% 1.1% 1.7%

Business conditions

Improve significantly 8.3% 10.0% 3.7% 1.5% 4.5% 16.7% 7.5%

Improve slightly 66.7% 50.0% 51.9% 61.5% 61.4% 45.4% 56.2%

Stay the same 25.0% 30.0% 33.0% 15.4% 22.7% 18.4% 24.1%

Decline slightly 0.0% 10.0% 11.1% 18.5% 4.5% 12.1% 9.4%

Decline significantly 0.0% 0.0% 0.0% 3.1% 6.8% 7.5% 2.9%

Returns to LPs (next 12 months) 15.0% 20.0% 12.0%

John K. PagliaAssociate Professor of FinanceSenior Researcher, Pepperdine Private Capital Markets Project

Bschool.pepperdine.edu/privatecapital

John.paglia@pepperdine.edu

Thank You!