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®. Kansas City. KC Private Equity Forum : Survival, Success & Succession. Dealmaking in Today’s Turbulent Markets: Where Do We Go?. Presented by: Jack Helms Chairman Lazard Middle Market jack.helms@lazardmm.com 612.339.0500. ®. Kansas City. JUNE 2009. STATE OF THE M&A MARKET.

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slide1

®

Kansas City

KC Private Equity Forum:

Survival, Success & Succession

Dealmaking in Today’s Turbulent Markets:

Where Do We Go?

Presented by:

Jack Helms

Chairman

Lazard Middle Market

jack.helms@lazardmm.com

612.339.0500

state of the m a market

®

Kansas City

JUNE 2009

STATE OF THE M&A MARKET
table of contents
Table of Contents

STATE OF THE ECONOMY

CREDIT MARKET

PRIVATE EQUITY

KANSAS AND MISSOURI ACTIVITY

M&A MARKET

cyclicality in the m a market
Cyclicality in the M&A Market

S&P 500 LTM EPS (Proxy for U.S. Economy)

Deal Volume

S&P 500 Index

Index

LTM EPS

# of Deals

$1,600

14,000

$90

$80

$1,400

12,000

$70

$1,200

10,000

$60

$1,000

8,000

$50

$800

$40

6,000

$600

$30

4,000

$400

$20

2,000

$200

$10

$0

0

$0

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

Source: Mergerstat and S&P

M&A volume is clearly linked to the state of the economy and is highlycorrelated with equity market performance.

public market indexes over time
Public Market Indexes Over Time

(55.6%)

(53.8%)

% of Index

(56.8%)

S&P 500 Index

Dow Jones Industrial Average

NASDAQ Composite Index

Source: CapitalIQ, updated through 6/2/09

Note: Indexed off of September 1989

From peak to trough the DJIA, S&P and NASDAQ were down 53.8%, 56.9%and 54.8%, respectively.

public market indexes over time7
Public Market Indexes Over Time

$100 invested equally in 3 indexes on 9/1/89

$430

$400

$255

$200

$200

$190

$100

S&P 500 Index

Dow Jones Industrial Average

NASDAQ Composite Index

875.0

% of Index

~7 yrs

~7 yrs

Source: CapitalIQ, updated through 6/2/09

Note: Indexed off of September 1989

A long term view of public equity market valuations reflect: (i) the bizarre behaviorof the NASDAQ in 1999 (tech bubble) and (ii) the recent loss of 13 years of value appreciation.

comparison to 1929 stock market crash
Comparison to 1929 Stock Market Crash

Source: Capital IQ updated through 6/2/09

Is the bear dead, or is this just a “bull-bounce” in a continuing bear?

debt outstanding by sector over the past 15 years

$60

4.2x

$51

3.6x

2.7x

2.6x

2.4x

$26

$16

$14.3

$14.3

$9.8

$6.7

$150mm

Households

Business

State & Local Gov't

Federal Gov't

Debt/GDP

GDP

Debt Outstanding by Sector Over the Past 15 Years

Debt/GDP

$65

4.5x

60

4.0x

55

3.5x

50

45

3.0x

40

2.5x

35

30

2.0x

25

1.5x

20

15

1.0x

10

0.5x

5

0

0.0x

Great Depression

1993

2000

2008

2009E*

Source: Federal Reserve, Department of Commerce

Note: $’s in trillions

*2009 is Lazard estimate for illustrative purposes

There has been a dramatic increase in leverage since the Depression years.

federal government deficit analysis
Federal Government Deficit Analysis

Source: Congressional Budget Office data and estimates as of 5/6/09; www.cbo.gov

treasure quarterly net marketable borrowing

“Net Cash”Fiscal Quarter

Borrowings

Paydown

Treasure Quarterly Net Marketable Borrowing

Net marketable borrowing through the second quarter of FY 2009has eclipsed total FY 2008 net marketable borrowing.

non investment grade debt maturities over the next 5 years
Non-Investment Grade Debt Maturities Over the Next 5 Years

$3,594

$2,977

$2,364

$1,695

$1,017

$459

Source: Bloomberg and S&P as of 3/31/2009

Note: $’s in billions

Over $1.5 trillion in non-investment grade debt is coming due over the next 5 years.

credit providers

Shadow Banking System

Others

GSE and ABS

Funds

Insurance

Credit Providers

$ in tn

Traditional Banking

Source: “Downunder Daily”. Morgan Stanley Research. 1/28/09. Asset Backed Alert. www.abalert.com.

Traditional banking lacks the capacity to service current debt levels.

Equalization and government intervention will be the primary solutions.

death of the securitization market
Death of the Securitization Market

US SECURITIZATION ISSUANCE

Source: “Downunder Daily”. Morgan Stanley Research. 1/28/09. Asset Backed Alert. www.abalert.com.

slide17

Percent of Leveraged Loans in Payment Default or Bankruptcy

Source: Standard and Poor’s LCD and S&P/LSTA Leveraged Loan Index

Note: Comprises all loans, including those not tracked in the LSTA/LPC mark-to-market service

Note: Vast majority are institutional tranches

Note: 2009 Projection from Edward Altman, Stern School of Business, NYU

2009 default rate expected to end higher than 2002.

Current shadow default rate is 11.3%.

u s housing still a problem
U.S. Housing Still A Problem

Housing Inventory

Monthly Housing Starts

Source: U.S. Census Bureau

Source: U.S. Census Bureau

Average Sales Price of New Homes

Commercial Real Estate Vacancies

Source: U.S. Census Bureau

Note: Sales price include the land

Source: CB Richard Ellis (historical), National Association of Realtors (projections)

Note: Retail vacancy data only available back to 2005.

bull case
Bull Case

SHORT TRADERS

slide20

Dow Jones Industrials Performance Post Bottom (3/9/2009)

+46%

+38%

+34%

Source: Yahoo Finance as of 6/9/09

equity mutual fund inflow vs djia
Equity Mutual Fund Inflow vs. DJIA

Δ in DJIA

10%

$20,000

$10,000

5%

0%

$0

-$10,000

(5%)

(10%)

-$20,000

-$30,000

(15%)

(20%)

-$40,000

(25%)

-$50,000

Jul-08

Jul-08

Aug-08

Sep-08

Oct-08

Nov-08

Dec-08

Jan-09

Feb-09

Mar-09

Apr-09

Equity Mutual Funds Inflows (mm)

DJIA

Source: TrimTabs Investment Research

Note: $’s in millions

cash held on the sidelines currently at historical highs
Cash Held on the “Sidelines” Currently at Historical Highs

Source: Bloomberg and Factset

Cash “on the sideline” is at an all-time high compared to the value of equity markets.When will “in-flow” to equity funds begin?

u s manufacturing and services
U.S. Manufacturing and Services

Inventories and Orders

Inventory lags new orders and is shrinking. New orders are rising, causing an increase in new production due to low inventory. Possible increased demand for labor?

Source: Institute for Supply Management

ISM Services Index

ISM Services Index has turned. Services drives economy much more than manufacturing.

As of 5/09. Blue-shaded areas indicate periods of recession. See last slide for definition of recession. Source: Bureau of Economic Analysis, FactSet, Institute of Supply Management (ISM), National Bureau of Economic Analysis (NBER).

housing inventories moving down
Housing Inventories Moving Down

New

New home inventories fully reversed bubble

Existing

Foreclosures still feeding into existing home inventories

As of 4/09. Blue-shaded areas indicate periods of recession. See last slide for definition of recession. Source: Department of Commerce, FactSet, National Association of Realtors, National Bureau of Economic Research (NBER).

home prices appear to be stabilizing
Home Prices Appear to be Stabilizing

Note: As of 3/09. Based on S&P/Case-Shiller composite 20 Home Price Index. Source: FactSet, Standard & Poor’s .

consumer confidence jobless claims
Consumer Confidence – Jobless Claims

Source: Bloomberg and Factset

Have the bad things stabilized, and is confidence returning? Or, are they just taking a rest before continuing?

layoff announcements down noticeably
Layoff Announcements Down Noticeably

Layoffs

Layoff announcements as of 5/09. Unemployment claims as of 5/29/09. Blue-shaded areas indicate periods of recession. See last slide for definition of recession. Source: Challenger Gray & Christmas Inc., Department of Labor, FactSet, National Bureau of Economic Research (NBER).

Layoff announcements are a true forward indicator.

no signs of inflation
No Signs of Inflation
  • Traditional definition of Inflation

Too many dollars

chasing

too few goods

money supply and velocity

Fed flooding system: could reach $3.5T by year-end

But “velocity” of money remains depressed (money not getting into economy)

Money Supply and Velocity

As of 6/09.Source: FactSet, Federal Reserve.

too few goods
Too Few Goods?
  • The chart to the left from Goldman Sachs studies the Output Gap since 1960 as a measure of how the actual GDP can rise above or below its potential long-term average and its relationship with inflation.
  • Some economists believe that deflation is a near-term threat due to the recent shock to the global financial system.

The Output Gap Drives Inflation

Note: Dotted lines denote GS forecasts.

Source: Department of Commerce, CBO & Goldman Sachs Estimates (4/09)

consumer debt and personal savings
Consumer Debt and Personal Savings

Change in Liabilities

Consumer debt is contracting massively

Consumer net increase in liabilities as of 4Q08. Personal savings rate as of 4/09.Source: Bureau of Economic Analysis, FactSet, Federal Reserve.

Personal Savings as a Percentage of After-Tax Income

Americans are saving more of their paychecks than at any time since February 1995. Could prolong the recession, but will strengthen the financial health of U.S. households and overall economy for the long term.

5.7%

Source: Department of Commerce

anemic bull
Anemic Bull
  • Headwinds for the Emerging Bull
  • Rising Energy Costs
  • Rising Interest Rates
  • Continued Consumer Delevering
  • Increasing Taxes
    • Increase in top rate, cap gains rate, dividend rate
    • Offshore income
    • Healthcare plans
    • Social Security
  • National Health
  • Radical Increases in Regulation
leveraged loan volume trends

$535

$480

(71%)

$295

$265

$256

$243

$185

$153

$166

$139

$139

$46

$11

(76%)

Leveraged Loan Volume Trends

$600.0

U.S. Dollar Denominated New-Issue Leveraged Loan Volume

$500.0

$400.0

In Billions

$300.0

$200.0

$100.0

$0.0

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

1Q08

1Q09

Source: Standard & Poor’s, LCD Leveraged Lending Review 1Q09

Note: Excludes existing tranches of add-ons and amendments and restatements with no new money

Leveraged loan volume was down 75% year-over-year, but up 30% compared to 4Q’08.

34

middle market loan volume trends pro rata and institutional middle market volume by year
Middle Market Loan Volume Trends–Pro Rata and Institutional Middle Market Volume By Year

Source: Standard & Poor’s, LCD Leveraged Lending Review 1Q09

Note: Middle Market defined up to $50 million of EBITDA

Note: $’s in billions

Institutional investors have all but left the middle market.

credit providers37

Shadow Banking System

Others

GSE and ABS

Funds

Insurance

Credit Providers

$ in tn

Traditional Banking

Source: “Downunder Daily”. Morgan Stanley Research. 1/28/09. Asset Backed Alert. www.abalert.com.

Traditional banking lacks the capacity to service current debt levels.

Equalization and government intervention will be the primary solutions.

slide38

Fund Managers That Issued Arbitrage CLOs by Year

Source: Standard & Poor’s LCD, Leveraged Lending Review 4Q08

2008 CLO volume down 85%.

2007 volume: $87 billion – 2008 volume: $13 billion – 2009 YTD volume: $300 million.

slide39

U.S. Bond Markets

24-Month U.S. Investment Grade Issuance

The market for investment grade issues appears to have reestablished itself.

Source: Advantage Data and Bloomberg as of 06/10/09

24-Month U.S. High-Yield Issuance

The high yield markets show signs of spring and recovery.

Source: Advantage Data and Bloomberg as of 06/10/09

credit crisis resulting in unprecedented price declines
Credit Crisis Resulting in Unprecedented Price Declines

Average Discounted Spread of Leveraged Loans

Average Bid of Leveraged Loans (% of Par)

Last Date:

5/1/09

Ending Value:

L+1479

Last Date:

5/1/09

Ending Value:

75.1%

Source: Standard & Poor’s, LCD LoanStats Weekly as of 5/7/09

Note: Assumes discount from par is amortized evenly over a three-year life

Primary and secondary trading levels depressed by a liquidity vacuum.

Cause: CLO liquidations, portfolio fire-sales, record hedge/mutual fund redemptions.

Result: Limited number of active buyers reaping the benefit of forced-selling by many sellers.

39

slide41

Average Debt Multiples of Highly Leveraged Loans

8.8

7.1

6.7

(36%)

Source: Standard & Poor’s LCD, Leveraged Lending Review 4Q08

Transaction leverage is at a 22-year low.

middle market total leverage multiples
Middle Market Total Leverage Multiples

Source: Standard & Poor’s, LCD Middle Market Lending Review 1Q09

Note: Defined as issuers with EBITDA of $50 million or less

Note: For Q1’09, average leverage level is the Firm’s internal estimate

Starting and ending attachment points for mezzanine debt continue to decline, reducing risk for lenders.

Middle Market leverage was lower than overall market (see previous slide) prior to 2000, higher from 2001 through 2008, and is now lower.

41

slide43

Average Cash Flow Multiples of Highly Leveraged Loans (Cash Flow Coverage)

+55%

Source: Standard & Poor’s LCD, Leveraged Lending Review 4Q08

Cash flow coverage of new issue loans strongest in 22 years.

capital structures are more conservative

Equity

Rollover Equity

Sub

Senior

Capital Structures are More Conservative

AVERAGE SOURCES OF PROCEEDS FOR MIDDLE MARKET LBO LOANS

2007

2008

2009E

Source: Standard & Poor’s, LCD Leveraged Buyout Review 1Q09

Note: Defined as issuers with EBITDA of $50 million or less

Capital structures continue their trend toward more equity.

43

pricing of credit
Pricing of Credit
  • Post-Lehman
  • Pre-Lehman

SENIOR DEBT

(B Rated Credit)

Rate

Libor Floor

Fees

5%

No Libor floor

1%

5-8%

W/& w/o Libor floors

1%

ABL

Rate

Libor Floor

Spread

Fees

7-9%

No Libor floor

L+450

1-2%

10-12%

Libor floor of 3-4% plus L+600-700

2-4%

Cash Flow

SUB DEBT

Rate

Cash Pay

PIK

Warrants

15-18%

10-12% plus

3-5%

No warrants

18-20%

12% plus

6-8% and/or

Warrants

Source: Lazard Middle Market Credit Overview and Standard & Poor’s, LCD ABL Lending Review Q109

Note: ABL includes DIP financing

pricing of risk
Pricing of Risk

Yields on 5-year U.S. Treasuries drop while yields on AAA/AA-rated bonds and BB+ and below rated bonds jump dramatically.

Spreads over 5-year U.S. Treasuries jump substantially more for BB+ and below rated bonds when compared to AAA/AA-rated bonds.

Source: LehmanLive

2003 2007 m a market49
2003-2007: M&A Market

ANALYSTS’ RESEARCH LAB

2003 2007 m a market50
2003-2007: M&A Market

PAT HEALY (C3 CAPITAL)

halloween 2008
Halloween 2008

“WHICH IS MORE SCARY?”

private equity total deal flow58
Private Equity Total Deal Flow

$200

800

$180

700

$160

600

$140

500

$120

$100

400

$80

300

$60

200

$40

100

$20

$-

-

Q1 '04

Q2 '04

Q3 '04

Q4 '04

Q1 '05

Q2 '05

Q3 '05

Q4 '05

Q1 '06

Q2 '06

Q3 '06

Q4 ' 06

Q1 '07

Q2 '07

Q3 '07

Q4 '07

Q1 '08

Q2 '08

Q3 '08

Q4 '08

Q1 '09

Number of Deals

private equity total deal flow59
Private Equity Total Deal Flow

$200

800

$180

700

$160

600

$140

500

$120

$100

400

$80

300

$60

200

$40

100

$20

$-

-

Q1 '04

Q2 '04

Q3 '04

Q4 '04

Q1 '05

Q2 '05

Q3 '05

Q4 '05

Q1 '06

Q2 '06

Q3 '06

Q4 ' 06

Q1 '07

Q2 '07

Q3 '07

Q4 '07

Q1 '08

Q2 '08

Q3 '08

Q4 '08

Q1 '09

Number of Deals

private equity total deal flow60
Private Equity Total Deal Flow

$200

800

$177

$180

700

$160

600

$143

$140

$128

500

$118

$120

$96

$100

400

$80

$71

300

$67

$60

$60

$53

$48

200

$41

$40

$37

$35

$35

$40

$29

$28

$27

$19

100

$18

$20

$13

$-

-

Q1 '04

Q2 '04

Q3 '04

Q4 '04

Q1 '05

Q2 '05

Q3 '05

Q4 '05

Q1 '06

Q2 '06

Q3 '06

Q4 ' 06

Q1 '07

Q2 '07

Q3 '07

Q4 '07

Q1 '08

Q2 '08

Q3 '08

Q4 '08

Q1 '09

Capital Invested ($B)

Number of Deals

Source: PitchBook

Capital invested by PEGs has fallen dramatically, indicating substantial equity capacity

m a deals strategic vs financial
M&A Deals – Strategic vs. Financial

$450

3,500

$400

3,000

$350

2,500

$300

2,000

$250

$200

1,500

$150

1,000

$100

500

$50

$-

-

Q1 ' 06

Q2 '06

Q3 '06

Q4 '06

Q1 '07

Q2 '07

Q3 '07

Q4 ' 07

Q1 '08

Q2 '08

Q3 '08

Q4 '08

Q1 '09

$32

$69

$139

$133

$141

$305

$46

$38

$15

$36

$19

$7

$4

PEG $

$331

$329

$212

$326

$308

$388

$240

$211

$135

$265

$308

$92

$253

Strategic $

517

543

592

552

658

702

665

619

590

412

440

279

188

PEG #

2,406

2,708

2,612

2,561

2,825

2,898

2,618

2,631

2,436

2,449

2,481

1,954

1,517

Strategic #

$ in billions

Deal Volume

Source: CapitalIQ

In number of deals, PEG’s market share stays consistently small.

In value of deals, PEGs win large deals when credit markets reach their most aggressive level.

slide62

Percent of Private Equity Transactions by Deal Size

Source: Pitchbook

The percentage of capital invested in larger deals expanded rapidly from 2002 to 2007, and then declined since 2007 as investors have recently focused their resources on smaller, more accessible deals.

deal structure average equity contributions to lbos
Deal Structure – Average Equity Contributions to LBOs

Source: Standard & Poor’s LCD, Leveraged Lending Review 4Q08

YTD 2009 deals involve more than 50% equity.

slide64

Private Equity Divestitures

Source: Pitchbook

Divestitures in the up-cycle (’04 through ’07) increased to record levels, driving distributions, feeding new fund raises.

As no surprise, divestitures now are limited to distressed or very special situations.

slide65

Private Equity Fund Raising

Capital Raised by Fund Size

Fund Count by Fund Size

Source: Pitchbook

Large funds continue to raise a disproportionately large portion of capital and in Q1 2009, funds between $500 million and $1 billion received a slightly larger than normal percentage of funds raised.

Funds bellow $1 billion accounted for the majority of funds, but larger middle market funds ($500 million to $1 billion) are proliferating since 2007.

slide66

$500

$500

$400

$400

$400

$400

$378

$378

$292

$292

$300

$300

$263

$263

$232

$232

$230

$230

$222

$222

$198

$198

$237

$237

$200

$200

$150

$150

$77

$77

$100

$100

$43

$43

$0

$0

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

-$100

-$100

Capital Overhang

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Equity Invested

Capital Raised by Funds

Overhang (By Year)

Overhang (Cumulative Total)

Source: Pitchbook

slide68

Private Equity and Mezzanine Investors Universe

Office Location

Office Location

Office Location

Office Location

Kansas

Kansas

5

5

Kansas

Kansas

2

2

Missouri

Missouri

26

26

Missouri

Missouri

5

5

Portfolio Company Industry

Portfolio Company Industry

Portfolio Company Industry

Portfolio Company Industry

Industrial Products and Manufacturing

92

Industrial Products and Manufacturing

33

Consumer

Consumer

68

68

Consumer

23

Technology

26

Technology

6

Healthcare

Healthcare

15

15

Healthcare

4

Business Services

5

Business Services

13

Media and Communications

4

Media and Communications

11

11

Food and Agriculture

2

Food and Agriculture

4

Fund Size (mm)

Fund Size (mm)

Fund Size (mm)

Fund Size (mm)

$100 and under

$100 and under

1

1

$100 and under

$100 and under

5

5

$100

$100

-

-

$300

$300

1

1

$100

$100

-

-

$300

$300

3

3

$300 and above

$300 and above

2

2

$300 and above

$300 and above

5

5

N/A

N/A

3

3

N/A

N/A

18

18

Source: Capital IQ

slide69

Kansas and Missouri Headquartered Sponsor-Backed Companies

Portco Office Location

Kansas

158

Missouri

266

Industry

Industrial Products and Manufacturing

131

Consumer

88

Technology

67

Healthcare

41

Business Services

56

Media and Communications

22

Food and Agriculture

19

Revenues (mm)

$50 and under

109

$50 - $500

55

$500 and above

25

N/A

235

Source: Capital IQ

m a activity volume by year
M&A Activity – Volume by Year

$1,500

(68%)

(68%)

$1,350

(34%)

(34%)

$1,200

(42%)

(34%)

$1,050

$900

$750

$600

$450

(37%)

$300

$150

$0

15,000

13,500

Recession

12,000

10,500

9,000

7,500

6,000

4,500

3,000

1,500

0

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

1Q08

1Q09

Source: Mergerstat

Deal Volume: 2000-2002 – 34% decrease; 2006-2008 – 34% decrease; 1Q08-1Q09 – 37% decrease

Deal Value: 2000-2002 – 68% decrease; 2006-2008 – 42% decrease

the lower and middle market thesis
The Lower and Middle Market Thesis
  • Middle Market vs. Large Cap Market
  • Higher deal volume
  • Less cyclical
  • Less competitive and less efficient market
  • More value-add opportunities with less mature companies
  • Higher equity returns
m a activity volume by deal size
M&A Activity – Volume by Deal Size

2009

2008

2007

# of Deals

2006

2004

2005

(70%)

(73%)

(86%)

Source: Mergerstat

Deal volume in the “lower middle market” has declined steadily since 2005.

number of deals by industry
Number of Deals by Industry

Source: Factset Mergerstat

Only 3 of 49 industries have seen an increase in deal volume activity since Q1 2008.

top 20 transactions announced or closed since september 2008
Top 20 Transactions Announced or Closed Since September 2008

Three industries account for 82% of all deal value since September 2008

Source: Capital IQ

deals by industry

2008

2009

2008

2009

2008

2009

2008

2009

2008

2009

2008

2009

Capital Invested ($B)

Number of Deals

Deals by Industry

Business Products & Services (B2B)

Consumer Products & Services (B2B)

Financial Services

Energy

Healthcare

Information Technology

Source: PitchBook

deals getting done
Deals Getting Done

DEALS ON EITHER END OF THE SPECTRUM

  • High-Performance
  • Companies
  • Distressed Companies
deals getting done78
Deals Getting Done
  • High Performance Companies
  • Midwest software business serving insurance brokerage
  • $30 million revenue, $8 million EBITDA (21% CAGR)
  • Management remaining, reinvesting
  • Significant new products in pipeline
  • Exclusive Private Equity marketing process
  • SELLER ROAD SHOW
  • Valuation: $125 million
  • Funding
    • $25 million senior debt
    • $80 million new equity
    • $20 million management rolled equity
deals getting done79
Deals Getting Done
  • High Performance Companies
  • Midwest test & measurement business
  • $50 million revenue, $15 million EBITDA (12% CAGR)
  • Management remaining, reinvesting
  • Strong quality of earnings, solid growth prospects
  • Marketed to Strategics and Private Equity (targeted)
  • Non-competitive strategics: $110 million in cash (7.3x)
    • Dilutive math in year 1
    • Highly accretive in year 2
    • Accretive on historic valuation
  • PEG won deal at $100 million
    • Cash reduced to $85 million
    • Replaced with:
      • $10 million Seller Note (10% PIK)
      • Warrants with “kick” at 2.0x and 2.5x return to buyer, $15 million valuation
  • Funding = 40% senior debt; 60% equity
slide80

Number of Bankruptcy Related M&A Transactions vs. U.S. GDP

Source: Thomson Financial

The number of bankruptcy transactions is surprisingly low when viewed in the context of the economic cycle.

The lack of DIP and takeout financing is acting as a dam, with fast-rising water levels.

slide81

Default Rate

Assets in Bankruptcy

Bankruptcy Sales

Correlation Between Default and Bankruptcy sales

Source: Capital IQ

In 2002, bankruptcy sales expanded dramatically, following increases in default rates and bankruptcies.

Currently, bankruptcy sales could “explode” in volume when financing becomes available.

distressed m a observations
Distressed M&A Observations
  • Distressed M&A, both in-court and out of court, is just now beginning to increase for several reasons
    • Relatively early in the cycle
    • As to 363 sales, lack of DIP financing has been a deterrent to filing under Chapter 11
    • First-lien creditors impaired in this cycle  therefore, can credit bid
    • Lack of take-out financing, whether in-court or out-of-court
    • Incumbent lenders often rolling-over/restructuring debt, hoping to maximize outcome when company performance and the markets improve
deals getting done83
Deals Getting Done

DEALS ON EITHER END OF THE SPECTRUM

  • High-Performance
  • Companies
  • Distressed Companies
  • SOME DEALS IN THE MIDDLE
  • Private (Non-PEG)
    • Facilitate management or family succession
    • Sell before capital gain rate increases
  • PEG
    • Replace tired capital; focus resources ($ and time)
    • Meet shareholder liquidity needs
  • Strategics
    • Merger of equals
    • Meet shareholder liquidity needs
  • Delever Through Sale of Non-Control Equity Position
    • Filing the GAP
    • PIPEs and RDs form public companies
deals getting done84
Deals Getting Done
  • Merger of Equals
  • Two national commodity chemical manufactures
    • Subsidiary of European conglomerate
    • Subsidiary of PEG-held portfolio company
  • Each with $300 million in Revenue and $5 million in EBITDA
  • Highly cyclical end markets, overcapacity
  • Both are sellers, but not for less than cost (book) of $100 million +/-
  • Merger integration allows closing 3 of 7 plants; purchasing, R&D, and G&A savings
  • EBITDA: 5 + 5 = 10 + 45 = 55
  • Asset based lending allows for $80 million in new funding
  • Neither would allow other to have control
  • New PEG invests with management to own 15%
capital gap
Capital Gap

Source: Factset and Bloomberg

purchase price multiples decrease
Purchase Price Multiples Decrease

10.0x

$100

9.4x

8.9x

8.8x

8.8x

$90

8.7x

8.4x

9.0x

$80

8.2x

7.9x

7.8x

$70

7.5x

8.0x

7.1x

$60

6.9x

6.8x

7.0x

$50

6.3x

$40

6.0x

$30

$20

5.0x

$10

4.0x

$0

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

09 YTD

EBITDA Multiple

Source: Mergerstat

Note: Deal Size $10 million to $500 million, excluding negative and multiples over 25

Reported EBITDA multiples are down from record levels.

Why do multiples peak in higher earnings years and fall in lower earnings years?

lower valuations
Lower Valuations
  • Reduced Expectations
  • Increased discount rates against future cash flows
    • “Time value costs” very low now, will increase
    • Price of risk – very high
    • Increased cost of capital
      • Less leverage
      • More expensive leverage
      • More equity
time and performance
Time and Performance

Performance

Time

s p eps vs median purchase price as multiple of ebitda
S&P EPS vs. Median Purchase Price as Multiple of EBITDA

10.0x

$100

9.4x

8.9x

8.8x

8.8x

$90

8.7x

8.4x

9.0x

$80

8.2x

7.9x

7.8x

$70

7.5x

8.0x

7.1x

$60

6.9x

6.8x

7.0x

$50

6.3x

$40

6.0x

$30

$20

5.0x

$10

4.0x

$0

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

09 YTD

EBITDA Multiple

S&P 500 LTM EPS

Source: Mergerstat

Note: Deal Size $10 million to $500 million, excluding negative and multiples over 25

Reported EBITDA multiples are down from record levels.

Why do multiples peak in higher earnings years and fall in lower earnings years?

recession investing makes great vintages
Recession Investing Makes Great Vintages

Source: Preqin; the Economist Intelligence Unit.

Note: IRR = internal rate of return

1 Buyout funds with a focus on the U.S. market.

structuring deals in the new world
Structuring Deals in the New World
  • Senior debt:
    • Funding at closing = 2.0x
    • Availability = 2.5x
  • Mezzanine:
    • Funding and closing = 1.0x
    • Emphasis on PIK and warrant coverage
  • 50% equity
  • Seller financing (PIK, subordinated, senior-like-pricing)
  • Earnouts
earnouts
Earnouts
  • Performance Based Payouts
    • Revenues
      • Favored by Sellers (simplicity, control)
      • Buyers concerned with conflicts (margin dilution, pipe stuffing, etc.)
    • Operating Profit
      • Favored by Buyers
      • Resistance from Sellers (accounting issues, investment spending, control, allocations)
    • Gross Margin
      • Reasonable compromise
      • Issues include COGS allocations, CAPEX implications, variable costs arguments, etc.)
    • New Rules (FASB 141(R) and 160)
      • Fair value inclusion for Buyers
      • Counter intuitive result for Buyers
      • New cottage industry for “fair value”
      • Significant complexity for strategic buyers in calculating IRR’s and accretion/dilution models for preparing bids and negotiating/structuring deals
earnouts94
Earnouts
  • Performance Based Payouts (cont.)
    • Disconnect in Risk/Reward Equation

Illustration:

      • Solution: Performance-Based Earnout
    • Theoretical structure (Seller’s view)
      • Issue $14.0 million note at close, due in 16 months
      • Principal adjusted pro rata based on achieving $2.0 million in earnings growth
    • Practical Issue
      • Strategic buyer can (but doesn’t like to) fund, with stock and/or cash
      • Private Equity rarely is able to structure second stage funding from lenders, and rarely consents to equity funding for earnout
    • Conventional Solution
      • Note is paid over time, or
      • Buyer pays seller X% of (revenues, gross profit, or EBITDA) in excess of ($12.0 million for Y years)
earnouts95
Earnouts
  • Performance Based Payouts (cont.)
    • Valuation Disconnect
      • For Seller to receive $14.0 million, the company will need to grow substantially beyond the original payout target (loss of residual value)
    • Funding Issues Remain
      • For Buyers, paying the earnout may create cash flow bind when company performance is strong
      • Often, buyers also face unexpected covenant barriers to payment
earnouts96
Earnouts
  • Retained Equity/Warrants
    • Win/Win Solutions

Illustration:

    • Solution:
      • Cash price at closing of $70.0 million (assume $35.0 million in debt and $35.0 million in equity)
      • Capitalize company with $35.0 million preferred stock, with PIK dividend, convertible into common at deal valuation
      • Issue 29% of common (full conversion of preferred as of closing) to sellers

14 / (35+14) = 29%

      • PIK on preferred is negotiated and set so that seller’s percentage of common stock is diluted as company performance falls below hurdles, and visa versa for greater performance
earnouts97
Earnouts
  • Benefits
    • No accounting issues
    • Complete alignment on all strategy matters (investment spending, CAPEX, pricing, hiring, compensation, etc.)
    • No funding issues
    • Seller receives full residual value
  • Drawbacks
    • Seller is not in control
    • Seller’s timing is deferred
    • Buyer pays more (for performing companies)
    • Buyer has a partner, with full transparency
structuring convertible preferred
Structuring Convertible Preferred
  • Heighted arm wrestling over use of traditional convertible preferred vs. non-convertible preferred with detached common

Illustration:

    • Situation:
      • Portco is acquired for $100.0 million – $50.0 million debt, $50.0 million equity
      • Gap between bid and ask is approximately $12.5 million
      • Portco’s EBITDA grows from $15.0 million to $25.0 million in 4 years, and is sold
      • If conventional earnout was used, with Seller getting 50% of EBITDA in excess of $15.0 million for 4 years, Seller would receive approximately $11.0 million over 4 years which is likely to be taxed as ordinary income
      • Instead Seller receives “20% retained interest”
    • Convertible Structure:
      • Sale at $175.0 million after year 4
      • After debt proceeds of $125.0 million
      • If preferred had no PIK, and conversion was straight up:
        • Buyer – 80% – $100.0 million
        • Seller – 20% – $25.0 million
      • If preferred has PIK @ 10%
        • Buyer – 85% – $106.0 million
        • Seller – 15% – $19.0 million
slide99

Structuring Convertible Preferred

  • Detached Common
    • Preferred paid as if debt
    • If no PIK, proceeds to common are reduced from $125.0 million to $75.0 million
      • Buyer – 80% – $60.0 million (plus $50.0 million)
      • Seller – 20% – $15.0 million
peg strategy for tomorrow
PEG Strategy for Tomorrow
  • Many firms are out of the new platform market
    • Difficult portco performance
    • Diminishing and critical investor base
    • Estimates range from 20% to 50% of current firms will disappear
  • Economic Headwinds Create Change
    • Dynamic markets and industries
    • Increasing premium on efficiency
    • Increasing need to “catch a wave”; a few examples:
      • New healthcare paradigm
      • Emerging technologies
      • Exploit regulated markets
      • Be right on timing in energy related/influenced businesses
      • Select infrastructure opportunities (those that generate (not require) government funding)
  • Rewards for strategy/more than structure
slide101

School forPrivate Equity

Don’t Miss The Big Picture

slide102

®

Kansas City

KC Private Equity Forum:

Survival, Success & Succession

Dealmaking in Today’s Turbulent Markets:

Where Do We Go?

Presented by:

Jack Helms

Chairman

Lazard Middle Market

jack.helms@lazardmm.com

612.339.0500