Private Capital Markets

Private Capital Markets

Presented by Rob Slee, CM&AA, MA, MBA

© 2015 Robert T. Slee. All Rights Reserved. 1

Private Capital MarketsSlee

Today’s Talk:I. Public versus private marketsII. Middle Market FinanceIII. Everything you need to know about value

creationIV. Everything you need to know about M&A

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What are the Private Capital Markets?• The venues where private capital is raised and

private equity interests are exchanged

The world’s biggest markets?

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Capital Markets Overview

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Sales($millions)

5 150 500 1,000

Small Lower Middle Upper Large

Businesses M I d d l e M a r k e t Companies

2-3x 4-7x 8-9x 10-11x >12x

5.4MM 300,000 2,000

15% 40% 45%


The Middle Market – What’s Happening?• The US middle market is one of the largest economies in

the world• There are 5,000-8,000 Private equity groups (PEGs) in

the US – with $1-2 trillion dollars in spending power• PEGs own around 35,000 middle market companies

(12%) – but this represents about 30% of the market equity…moving to more than 40% of equity by 2014

• Family Offices and Hedge Funds are newer to private investments – but they have far more than $1 trillion

• Realized returns are dropping like a rock

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Intermediated Value Gap

Middle Market InvestmentsExpected versus Realized Returns*

Investments ExpectedReturns

RealizedReturns**

5 Year 10 Year 20 YearVenture capital 38% 4.6% -1.5% 17.8%

Mezzanine capital 21% 2.7% 2.3% 6.7%

Private equity 25-30% 5.8% 2.8% 11.3%

*Thomson Reuters US Private Equity Performance Index (PEPI)**Realized returns are net to investors after management fees and carried interest.


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Owner Value Gap• Most lower middle market companies have a cost of

equity capital of 20-30%• Yet 70-80% of owners do not generate returns on equity

to cover this cost of capital• This means that over time, a value gap occurs (the

difference between what the owner wants/needs the value to be…versus what the market says it is worth)

• The value gap shows-up in a number of negative ways (lack of job creation; diminished GDP; lower loan demand, etc.)


Finance: What is Currently Taught• There is one primary capital market in the U.S.• Corporate finance theory explains behavior of the

players • Every business has one true value• Capital is efficiently allocated and priced• Going public is the primary goal of a business

owner• What’s the problem?

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Upon Further Review• Capital markets are segmented in the U.S.• Various finance theories explain behavior of the

players • Every business has dozens of correct values at

any point in time• Private capital is not efficiently allocated and

priced• More companies will go private than public for the

foreseeable future• A new belief system developing?

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Public and Private Capital Markets are Not Substitutes• Risk/return is different• Liquidity is different • Management involvement is different

Robert T. Slee, “Public and Private Capital Markets are Not Substitutes,” Business Appraisal Practice, Spring 2005.

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A Tale of Two Markets

Public Markets (Wall St.) Private Markets (Main St.)Use of a C corporation Can be any type entity (S, LLC, etc)

Value is established by a market Value is established at a point in time

Ready access to public capital markets No access to public capital markets

Owners have limited liability Owners have unlimited liability

Owners are well diversified Owners have one primary asset

Professional management Owner management

Company has infinite life Typical company life of one generation

Liquid securities efficiently traded Illiquid securities inefficiently traded

Profit maximization as goal Personal wealth creation as goal

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Capital Market Theories• Useful capital market theories explain, organize

and predict behavior of players in a capital market• Theory doesn’t always meet practice• Do corporate finance theories predict behavior in

private capital markets?

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Meta-Financial Theories

- Risk & Return- Rational Man/Market- Utility Theory- General Equilibrium Theory- Decision & Game Theory

Small Company Markets Theory

Corporate Finance Theory

Middle Market Finance Theory


Different Theories for Different Segments

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Sales($millions)

5 150 500 1,000

Small Lower Middle Upper Large

Businesses M I d d l e M a r k e t Companies

Small Company Markets Theory

Middle Market Finance TheoryCorporate Finance Theory


Capital Market Lines

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50%

40%

30%

20%

10%

0%

Expe

cted

Ret

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SmallMiddle

Large

Debt Mezzanine Equity


Middle Market Finance

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Middle Market FinanceTheory

Valuation

TransferCapital

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II. Middle Market Finance

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Middle Market Finance• The study of how managers of private middle market

companies make investment and financing decisions • Value Relativity: Value is relative to the reason for an

appraisal• The Bizarre Bazaar: Private capital is allocated in a

bazaar • Transfer Spectrum: Business transfer comprises a

spectrum of alternatives• You are lost until you understand the integrated

structure of private finance (story time…)

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Professional ‘Value’ Today• Historic and forensic • Compliance-oriented• Notional• Measured with singular certainty

But not the least bit useful in making investment and financing decisions

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Value World Theory• Motive leads to a reason for an appraisal• The reason for an appraisal selects a value world• A private business value is relative to the value

world in which it is viewed• Therefore every private company has dozens of

correct values at one point in time• Why is there value relativity? Because I say so…

NOT!

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A Few Value Worlds• Market Value – what the open market says the

business is worth (Asset, Financial, and Synergy Subworlds)

• Fair Market Value – what the IRS/Courts say it is worth• Owner Value – what the owner says it is worth• Investor Value – what an investor says it is worth• Collateral Value – what the bank says it is worth• Incremental Business Value – returns greater than

investment• Others: Insurable; Early Equity; Public; Fair Value• The 30 second rule

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What is Different in Each Value World?• One or more Authorities dictate a unique valuation

process used in a value world• In the case of competing Authorities, the one with the

more compelling argument usually wins• The benefit stream is different by world (return)• The return expectation is different by world (risk)

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Market Value• The highest price available in the marketplace for

the assets or stock of the company• These are open market values (you might refer to

them as a group of investment values)• 3 subworlds: Asset, Financial and Synergy• Brokers and asset appraisers are the Authorities• Most owners don’t want to transfer in the Asset

subworld (although…)

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Asset Market Value• The Subworld without operating goodwill• If the subject should be viewed in this subworld,

determine the net asset value• It’s a judgment call regarding using liquidation

values, fair market values, or market values of assets

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Stream versus Multiple• Financial and Synergy market value:

Equals the “Stream times the Multiple”(EBITDA times an acquisition multiple)

The Stream is influenced by the presenter The Buyer brings the multiple

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It’s a Recast World• Which earnings level do you use to value?

Reported EBITDA $1MM Recast EBITDA $2MM Synergized recast EBITDA $3MM

Using a ‘5’ multiple, the same company has a $5MM, $10MM, and $15MM market value – depending on which earnings level is used


Financial Market Value

Subject Profile: Positive earning capacity Investor Profile: Individual/NonstrategicProcess: Recast EBITDA times a multiple

Seller keeps Cash + RE + LTD; Buyer takes Operating assets plus assumes Current liabilities

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Synergy Market Value

Subject Profile: Positive earning capacity plus a cherished market position

Investor Profile: SynergisticProcess: Synergistic recast EBITDA

times a multiple

Only “hard” synergies need apply (PCMs – p. 98)

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Market Value - Conclusion• Most private owners want to increase the value of

their company in this world• Risk – acquisition multiple is specific to a buyer and

reflects their risk assessment (hurdle rate)• Return – EBITDA available post-transaction• Big opportunity for us to help owners plan and

execute

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Fair Market Value • Most IRS/Tax Courts/ERISA laws… are the

Authorities in this world• Are we trying to do too much in this world?• Will FMV ever mirror the reality of the market?• Private Cost of Capital Model (PCOC)• Can PCOC be used across value worlds?

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The Bizarre Bazaar of Private Capital• Why a bazaar and not a supermarket?• There is a structure and rules• Be prepared for financial hand-to-hand combat• Realize that capital providers constantly move their

tents• Need to create capital solutions one deal at a time

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Structure of the Bazaar• Private capital owner motives include a desire: for few

shareholders; to stretch equity; to eliminate personal guarantees; to manage business – not balance sheet

• Capital is allocated based on the credit requirements of the providers (credit box)

• Capital providers have unique return expectations• Return expectations are all-in rates (not just stated interest rates)• Let’s review this structure in more depth

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Mezzanine - Capital Coordinates

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Definition Subordinated debt that relies on cash interest, payment in kind (PIK), plus warrants for its return

Required Rate of Return 19.5% (pretax median return expectation - $10MM)

Likely Provider SBICs, private funds

Value World (s) Market value

Transfer Method (s) Private and Public Auction

Appropriate to Use When… The subject is experiencing high growth but has little free liquidity. Mezzanine is often the next type of capital to add to the capital structure if senior lending becomes restricted because mezzanine is less expensive than equity.

Key Points to Consider Beyond the 11-12% current coupon interest rate, a provider will structure a fairly heavy warrant position. The longer this warrants goes unexercised, the more costly it becomes to the investee.

Performance ratchets may be used to incentivize management to reach performance targets.


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Mezzanine – Credit Box

To Qualify for Mezzanine Capital, an Applicant Must:• Have terrific growth prospects, at least 20% compounded per year• Have a management team experienced in high-growth situations• Have sufficient cash flow beginning in year 2 to enable payment of

principal and interest• Have total debt to EBITDA no more than 3.5• Employ a capital structure that puts the mezzanine in no worse than a

second lien position• Possess a scalable business model• Have some equity support


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Mezzanine – Sample Terms

Example Loan: $7 million loan

Interest Rate: 12% fixed, payable monthly PIK interest = 2%

Term: Interest only for 12 monthsMonthly principal + interest on 10 year amortization, with all principal due in 5 years

Detachable Warrants: 5% of the fully diluted common

Commitment Fee: 1% of loan

Closing Fee: 2% of facility amount


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Mezzanine - Expected Returns1. Total Interest Cost ($7 million loan times 14% interest rate) $980,000

2. Warrant Cost ($1.73 million spread over 5 years) 346,000

3. Commitment Fee ($7 million Loan Amount times 1% divided by 5

years)14,000

4. Closing Fee ($7 million Loan Amount times 2% divided by 5 years)

28,000

Annual Returns of Loan $1,368,000

Expected Rate of Return($1,368,000/$7,000,000)

19.5%


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Pepperdine Private Capital Market LineLower Middle Market Expected Returns ($5-10M)

41.8%37.5%

30.0%

21.0%

8.0%5.0%

0%5%

10%15%20%25%30%35%40%45%

Banks ABL Mezzanine PrivateEquity

VentureCapital

Factoring

Capital Types

Expe

cted

Ret

urns

(%)

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Key Capital Issues• The Pepperdine Private Capital Market Line and surveys

have enabled Slee/Paglia to create the Private Cost of Capital Model

• Private cost of capital is 3-4 times higher than public cost of capital…relatively little private value is being created

• Intermediation in the private capital markets is inefficient• Credit boxes enable capital access and the ability to

reduce cost of capital• Most owners do not have a value creation framework


Business Transfer• Business transfer reflects all possible ways or methods

to transfer or exchange a private business interest• An owner’s transfer motive selects a transfer channel

(e.g., Employee channel)• Each channel contains numerous transfer methods

(e.g., ESOP or MBO)• Transfer methods select value worlds!

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Business Transfer Spectrum

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Employees Family Co-Owners Outside [Retire]

Outside [Continue] Public Charitable

Trusts

T R A N S F E R M O T I V E S

T R A N S F E R M E T H O D S

ESOPs Management

Buyouts/Ins Phantom Stock Stock Appre- ciation Rights

Charitable Remainder

Trusts Charitable

Lead Trusts

Outright Gifts SCINs Annuities GRATs FLPs IDGTs

Negotiated One-Step Private Auctions Two-Step Private

Auctions

Consolidate Roll-ups Buy and Build Recapitali- zations

Initial Public Offerings

Direct Public Offerings

Reverse Mergers

Going Private

INTERNAL TRANSFERS

EXTERNAL TRANSFERS

Buy/Sell Russian

Roulette Dutch

Auction Right of

First Refusal

T R A N S F E R C H A N N E L S


PERSONAL BUSINESS MARKET

Do Most Owners Want to Create Entity Value?• No – it’s about lifestyle for most. What’s wrong with this?• What are the three most important things in real estate

valuation? In business valuation?• Let’s play the transfer timing slots game


Private Market Timing

How to play this cycle?

U.S. Ten Year Transfer Cycle

Deal Recession Prime Selling Time Uncertainty (Buyer’s Market) (Seller’s Market) (Neutral Market)

1980 1983 1988 19901990 1993 1998 20002000 2003 2008 20102011 2013 2018 2020


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Owner Motives Matter – PrivateCo’s Values

Business Owners Choose a Transfer Value!

Method Value World Value

Buy/Sell Asset Market Value $ 2.4 MMMBO Investment Value 7.5 MMESOP Fair Market Value 9.2 MMEquity Recap Financial Market Value 12.0 MMNegotiated Owner Value 15.8 MMAuction Synergy Market Value 16.6 MMPublic Public Value 18.2 MM


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III. Everything You Need to Know About Value Creation


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Everything You Need To Know About Value Creation• We all choose our level of value/wealth based on how

we spend our time• The idea of personal hourly hurdle rates• Slee’s Law of value creation• cLadder versus vLadder


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The vLadder


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IV. Everything You Need to Know About M&A


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Paradoxes Shape M&A• M&A is more of a SPORT than a BUSINESS• Companies that NEED help the most are the least

WILLING to pay for it• A deal only STARTS once it has DIED• The LARGER the deal, the EASIER it is to close• The MORE you care about a deal the LESS likely it is

to close• The best referral SOURCES also have the MOST to

lose by making the referral• We can do EVERYTHING right yet still come up

EMPTY!


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Food for Thought• Given globalization, what should

intermediaries, owners and managers be doing now?

• How is globalization changing the middle market?

• How can we use Middle Market Finance to create substantial value?

• Final thing I want you to do

Private Capital Markets

Business

Transcript of Private Capital Markets