SRR Fall 2010 Valuation Journal

1. FALL 2010
PUBLIC & LARGE PRIVATE COMPANY EDITION
Unlocking the Complexity of
Performance Units with Total
Shareholder Return Requirements
■ 34
International Cost of Equity: The Science Behind the Art ■ 20
A Proposed Accounting “Game Changer” with Respect to Leases ■ 42
Separation Anxiety: Fair Value Implications of Issuing Debt and Preferred
Stock with Conversion Features and Other Options 47 ■

2. “…Companies are now
introduced to unanticipated
“tax paying” issues…”
– Q&A, Page 133
Dear Clients and Friends:
At SRR we work closely with public and large private companies to address a wide
range of complex financial issues.
Please take a look at the Table of Contents on page 2 to browse the full collection
of recent articles from our firm.
I have indentified a few pieces below that may be of particular interest to you.
If you have any questions or comments, please contact me.
Sincerely,
Mr. Jay B. Wachowicz, CFA
jwachowicz@srr.com ■ 248.432.1288
FEATURED ARTICLES
34 Unlocking the Complexity of 42 A Proposed Accounting “Game Changer”
Performance Units with Total with Respect to Leases
Shareholder Return Requirements
This article discusses the joint effort between U.S.
Commonly employed financial instruments such standard setters and their respective international
as stock options and restricted stock awards have counterparts to dramatically alter the accounting
advantages and disadvantages as contemplated by requirements associated with lease accounting.
equity investors and employees. One of the more recent Given the magnitude of real property from an expense
developments in this regard relates to the introduction structure standpoint, this article highlights various
of performance units with total shareholder return issues associated with this asset class specifically.
requirements. This article addresses the methodologies
utilized to value performance units, as well as the 47 Separation Anxiety: Fair Value Implications
associated value drivers.
of Issuing Debt and Preferred Stock with
Conversion Features and Other Options
20 International Cost of Equity: Many early-stage or credit-starved firms often turn
The Science Behind the Art
to convertible bonds or similar instruments to entice
As companies continue to expand operations to investors while limiting the near-term cash flow burden
locations throughout the world (including certain of interest payments. While convertibles can provide
emerging markets), the measurement of country risk the issuer much needed capital and operational
has become a key element of a valuation. This article flexibility, they can also create accounting and valuation
discusses the various methodologies used to estimate challenges at issuance, as well as in subsequent
an appropriate cost of equity for foreign countries. reporting periods.

3. Unparalleled expertise
Deep industry knowledge
Great to work with
INVESTMENT VALUATION & DISPUTE ADVISORY
BANKING FINANCIAL OPINIONS & FORENSIC SERVICES
www.srr.com
SRR is a trade name for Stout
Risius Ross, Inc. and Stout Risius
Ross Advisors, LLC, a FINRA
registered broker-dealer and SIPC
member firm.

4. C ON TEN TS
45 Funded vs. Unfunded
Secondary Transactions
4 30
Timothy F. Cummins and
Dana J. O’Brien – Cornerstone
Equity Investors, LLC
7
4 The Role of the Board in 30 Ownership Transition – Using
Mergers & Acquisitions Tax Advantaged ESOPs in a
Jeffrey S. Phillips and Challenging Credit Environment
Michael J. Levitin – Wilmer Hale Jeffrey S. Buettner
8 M&A and Financing
47 Separation Anxiety: Fair Value
Market Update
34
Implications of Issuing Debt and
Terrel G. Bressler
Preferred Stock with Conversion
and David E. West
Features and Other Options
12 Guest Article: The Benefits of Ryan A. Gandre
Mezzanine Financing for Middle
Market Companies 52 Guest Article: Common Mistakes
34 Unlocking the Complexity
Patrick Rond and Nicholas Observed in Insurance Related
of Performance Units
Stone – Key Principal Transaction Due Diligence
with Total Shareholder
Partners Corp. Christopher J. Veber –
Return Requirements
Equity Risk Partners
Jay B. Wachowicz and
Denis F. Cash
16 Dividend Recaps:
Trends and the Importance
6 36 55
55
Impact of Recent Market Trends
of Solvency Opinions on Section 1111(b)(2) Elections
38 Valuation Formulas in Involving Real Property
Aziz El-Tahch
Shareholders’ Agreements Jeffrey M. Risius, Jeffrey G.
Christopher P. Casey and Pelegrin, and Jesse A. Ultz
20 International Cost of Equity:
Aaron M. Stumpf
The Science Behind the Art
Jay B. Wachowicz and
42 A Proposed Accounting
Brian A. Hock
59
“Game Changer” with Respect
26 Medical Device and to Leases
Equipment Industry Overview Jason J. Krentler and
Robert J. Andrews, Jr., Denis F. Cash
Robert A. Hauptman, and
Craig T. Hickey 59 Warning! The Service Believes
S Corporations are Undervalued
Daniel R. Van Vleet
©2010

5. 63 Alternative Techniques in 101 Court Once Again Addresses
Valuing Real Estate Portfolios Insufficient Support for Damages
83
Jeffrey G. Pelegrin, Award in a Patent Case
Christopher P. Casey, and John R. Bone, Erich W. Kirr,
Joseph L. Torzewski and Allen Burt
68 In Re Sunbelt Beverage Corp.
Shareholder Litigation:
05
83 Auditing Self-Reporting
A Delaware Fair Value
Agreements
Case Analysis
John R. Bone and
Timothy F. Cummins
Jason T. Wright
71 When the Chain Breaks…
Assessing Damages in Cases 86 Building a Best in Class
105 Applying the Structured
Involving Disruptions to Complex Corporate Compliance Program
Settlement Concept to Divorces
Supply Chains Glenn C. Sheets
James M. Godbout,
Glenn C. Sheets and Daniel T. Carroll – AVITAS
Jacob M. Reed Financial, and John M.
90
McCulloch – AVITAS Financial
74 Guest Article: Fraud Risk
Management in the
Banking Industry 109 Guest Article: Reviewing Estate
Andrea J. Steinkamp – Guest Plans in Connection with Divorce
Contributor and Tina B. Solis – Joan K. Crain – BNY Mellon
Ungaretti & Harris, LLP 90 Managing Occupational Wealth Management
Fraud Risks
113 The Taxing Side of Divorce
Michael N. Kahaian and
Mary V. Ade
79
Jason T. Wright
116 Guest Article: Family Office
94 Proactive Planning for Challenges and Solutions
E-Discovery Challenges for Sustainability
Scott T. Wrobel and Michael P. Benetta Park Jenson –
Hindelang – Honigman Miller Bessemer Trust Company, N.A.
79 Making E-Discovery Work for Schwartz and Cohn LLP
You in International Arbitration 121 Reasonable Compensation: A
David N. Paris and 99 “Fundamentally Unsupported by Key Issue in Marital Dissolution
Tomoko Tatara the Facts”: Eighth Circuit Affirms Justin L. Cherfoli and
Dismissal of Financial Expert Christopher P. Casey
Neil Steinkamp
125 In Case You Were Wondering…
Mary V. Ade
128 A Preliminary Look at SRR’s
Restricted Stock Study
We welcome any comments, suggestions, or questions. Please refer to the end of each article for the individual Aaron M. Stumpf and
author contact information.
Robert L. Martinez
The SRR Journal is intended for general information purposes only and is not intended to provide, and should not
be used in lieu of, financial, accounting, legal or other professional advice. The publisher assumes no liability for
readers’ use of the information herein and readers are encouraged to seek professional assistance with regard to
specific matters. All opinions expressed in these articles are those of the authors and do not necessarily reflect the
views of Stout Risius Ross, Inc. or Stout Risius Ross Advisors, LLC.
The SRR Journal is also available online at www.srr.com.
SRR is a trade name for Stout Risius Ross, Inc. and Stout Risius Ross Advisors, LLC,
a FINRA registered broker-dealer and SIPC member firm.

6. The Role of the
Board in Mergers
& Acquisitions
Jeffrey S. Phillips – jphillips@srr.com
Michael J. Levitin – WilmerHale –
michael.levitin@wilmerhale.com
This article offers a brief overview of the role of the Board of ■ The interests of directors and senior managers in some
Directors in mergers and acquisitions. By better understanding transactions may not be entirely aligned.
the board’s role, directors (and officers) can increase stockholder
■ In the current environment, everyone is concerned about
value, reduce conflict within the organization, and mitigate
litigation.
litigation risk.
Returning to the two questions above:
Overview ■ ■ ■
■ Directors and officers play fundamentally different roles within
The question, what is the board’s role in M&A?, raises two separate
a corporation. Under Delaware law, “[t]he business and affairs
but related questions:
of every corporation . . . shall be managed by or under the
■ How does the role of the board differ from the role direction of a board of directors . . ..” As a practical matter,
of management? most companies are managed under the direction of the
board: the board oversees management, and management
■ How does the board’s role in M&A differ from the board’s role
is responsible for the company’s day-to-day activities. At the
in the company’s other business activities?
highest level, the board is responsible for approving or setting
the strategy for a business, and management is responsible
These questions arise for many reasons, including the following:
for executing that strategy. Expressing this allocation of
■ Directors are sensitive to the prerogatives of management but responsibilities colloquially, only the board can govern, and
focused on fulfilling their own responsibilities. only management can manage.
■ Many directors have experience with M&A, either as officers ■ The role of the board in M&A varies with the significance of
of their own companies, or directors of other companies that a transaction. Consistent with the role of the board generally,
have engaged in transactions, or as professional advisors – a board should be relatively uninvolved with insignificant
bankers, accountants, consultants, or attorneys – with transactions and increasingly involved as transactions
M&A expertise. become more significant. The board should be highly involved
in major, strategic acquisitions and in sales of the company or
■ Transactions that rise to the board-level are significant events,
all, or substantially all, of its assets.
but at many companies are sufficiently infrequent that directors
and management may not have thoroughly vetted procedures
or an adequate understanding of their respective roles.
©2010 4 ©2010

7. The Board’s Role in M&A Generally ■ ■ ■ ■ Cultural clashes
■ Failures in integrating the acquired business
It’s helpful to think of M&A as one of the ways that a company can
execute its business plan and deliver value to its shareholders. Directors should review these issues with management. On these
Directors play many roles within the organization, but among their issues, in particular, directors have a perspective that is informed
principal functions are: by a range of experience, sympathetic to the company’s goals, and
separated from the pressures of the deal, and directors have the
■ Setting strategy
standing to challenge over-optimistic assumptions and emphasize
■ Monitoring corporate performance and management the importance of integration.
■ Overseeing risk management
Board Responsibilities in Connection
■ Counseling the CEO on the most difficult challenges facing with a Sale of the Company ■ ■ ■
the business
On the sell-side, the situation is a bit different because a sale
■ Championing good governance
transaction, particularly a sale of the company as a whole, can
■ Offering constructive criticism be the best opportunity for stockholders to achieve a premium for
their investment. Here, too, the board’s principal role is strategy,
All of these roles are relevant to M&A. In practice, directors play the
governance, and oversight, with added considerations that arise in
same role in transactions that they do in all other aspects of the
connection with a sale. One of these considerations pervades the
company’s business – oversight and governance – with some roles
sales process; two arise at the commencement of any process.
and responsibilities that are specific to the M&A context.
■ In some transactions, generally known by the name of the
On the buy-side, the board’s higher level perspective provides a
leading Delaware case, Revlon, Inc. v. MacAndrews & Forbes
special vantage point from which the board can help maximize
Holdings, Inc., the board is obligated to secure the best price
stockholder value:
reasonably available for stockholders. While the precise
■ The board is responsible for approving a company’s strategic contours of the Revlon doctrine are beyond the scope of this
plan, and the board should evaluate proposed acquisitions in article, in general, a sale of the company for cash triggers
the context of that plan. Revlon duties. For this reason, boards should begin with the
end in mind: they should assume that their decisions may
■ The board has a strategic view of the company’s resources –
need to withstand scrutiny under Revlon, and they should act
both financial and managerial – and the board should
throughout the process to maximize stockholder value.
assess whether a proposed transaction is the best use of
those resources. ■ Before initiating a sales process, the board should assess
whether this is an opportune time to sell the company. Under
■ The board selects the CEO and can influence the selection of
Delaware law, the decision on whether to sell or not sell the
senior management. If the board wants the company to grow
company is a decision for the board. Even if the company
through acquisitions, the board needs to take appropriate steps
receives an offer at a premium to the company’s current
to ensure that the management team includes individuals with
market value, the board – with the assistance of its advisors –
the skills required to execute transactions and integrate the
can assess whether stockholder value would be maximized
businesses that are acquired.
by selling at that time, in response to that offer, or selling at
All of these are strategic, board-level issues that the board should a different point in the business cycle or at a different
evaluate – and that only the board can evaluate – before the point in the company’s development, taking into account
company embarks on an acquisition. the company’s long-term strategic plan and whether the
company’s stockholders are better served by the company
Consistent with their responsibility for strategy, governance, and remaining independent.
oversight, directors should bring a strategic perspective to their
■ With the assistance of its professional advisors, the board
review of proposed acquisitions that rise to the board-level.
should adopt a process that maximizes stockholder value.
Directors should carefully probe the financial underpinnings of
Under Delaware law, there is no single blueprint for the sale
proposed acquisitions, which may be premised on unrealistic
of a company, and the answer will vary depending on the
assumptions about growth and cost-savings. Directors should be
company’s situation. But, in general, a thorough market check
aware of the principal reasons why acquisitions do not achieve
before signing an agreement, and the ability to accept superior
their anticipated results, including:
offers that emerge after signing, help establish that the board
has endeavored to maximize value for stockholders. A good
■ Overpayment for the target
process also helps mitigate litigation risk.
■ An incomplete understanding of the business being acquired
(including its liabilities and intellectual property)
©2010 5 ©2010

8. While the sales process is unfolding, the board should oversee the ■ Management favors one transaction because it involves greater
process, guiding management and the company’s advisors with compensation for management than competing deals.
a view to maximizing stockholder value and fulfilling the board’s
■ A controlling stockholder will receive somewhat more
Revlon duties.
consideration per share than minority stockholders: a
At the conclusion of the process, the board will consider an control premium.
agreement establishing the terms of the sale. Under Delaware ■ A controlling stockholder’s preferences for the transaction (for
law, the board of a company that wishes to merge with another example, cash versus stock, taxable versus tax-free, or timing)
entity must adopt a resolution approving a merger agreement differ from the preferences of other stockholders, so that the
and declaring its advisability to the company’s stockholders. controlling stockholder is arguably getting a better deal than
Similar requirements apply to sales of all or substantially all of a other stockholders, even though it receives the same price per
company’s assets. share as other stockholders.
Directors want their decisions to withstand any legal challenge For convenience, we use the term “related-party transaction” to
that might be asserted in connection with a sale. Different legal describe both related party and conflict situations.
standards might apply to such a case; Revlon duties are discussed
above. Some board decisions will be subject to “business judgment” From the board’s perspective, a critical difference between a
review. The business judgment rule establishes a presumption that typical transaction and a related party transaction is that, when the
directors, in making a business decision, acted on an informed company is considering a related party transaction, the board must
basis and in good faith. If the business judgment rule applies, the step out of its role of oversight and governance and play a more
directors’ decision will be sustained if it can be attributed to a active role in the deal. In a related party transaction, management
rational business purpose, even if, with the benefit of hindsight, the or a controlling stockholder is on one side of the table. The board –
decision proves to have been unfortunate. The business judgment typically through a special committee – is literally on the other side
rule will not apply if the directors’ decision involves self-dealing or of the table, actively representing the interests of stockholders.
a conflict of interest, and the business judgment rule will apply only
In a related party transaction, or in evaluating a transaction that
if directors act with due care – the business judgment rule does not
involves a conflict, the board should form a special committee
protect gross negligence.
comprised solely of independent directors. (It is helpful if the
In connection with a sale of the company, a board typically committee consists of two or more directors.) The resolutions
requests a “fairness opinion” from a financial advisor. A sell-side establishing the committee should grant the committee broad
fairness opinion is an opinion as to whether the consideration to power, including the power not to recommend any transaction.
be received in a proposed transaction is fair, from a financial point The committee should have the authority to retain independent
of view, to a company’s stockholders. The opinion is typically advisors, including legal and financial advisors of the committee’s
accompanied by a presentation that assesses the value of the choosing. The financial advisor’s compensation should not
transaction, using several methodologies. be entirely contingent on the completion of a transaction. The
members of the committee should stay informed and be diligent;
Fairness opinions, together with presentations by management the committee should zealously represent its constituents and
and the board’s advisors, and the board’s own knowledge of should vigorously negotiate the terms of any deal.
the company, its industry, and its prospects, provide the key
foundation for directors’ exercise of due care and their informed, Conclusion ■ ■ ■
careful review of a proposed sale. The board’s active oversight of
The board’s principal responsibility is to protect and enhance
the sales process and its instructions to management and advisors
stockholder value. Mergers and acquisitions offer one way that
throughout the process should focus on ensuring that the directors
stockholder value can be increased.
obtain the best deal reasonably available for stockholders.
The board’s principal role is strategy, oversight, and governance.
Related-party Transactions ■ ■ ■ Except in the unusual case of a related party transaction, where the
Related-party and conflict transactions provide a contrast to the board must plan an active role in negotiating the deal, the board’s
typical buy- and sell-side situations, described above. Related- role in M&A is consistent with its responsibilities for strategy,
party transactions include any transaction with, but particularly a governance, and oversight.
sale of the company to, a controlling stockholder, management, or
On the buy-side, the board should make a number of strategic
an entity affiliated with a controlling stockholder or management
decisions before the company undertakes acquisitions, and
(including a buyout in which management is participating).
the board should review proposed acquisitions from a strategic
Conflicts of interest, or possible conflicts, can arise from many
perspective with a particular focus on the assumptions
circumstances, including:
that underlie the deal and the importance of integrating the
acquired business.
©2010 6 ©2010

9. On the sell-side, particular where the board is considering the sale
of the company, the board should assess the timing and adopt a
process. The board should stay actively involved throughout the
process, overseeing management and the company’s advisors.
At the conclusion of the process, the board should assess the
proposed agreement and determine whether to recommend it to
stockholders. Throughout, directors should act carefully and on an
informed basis.
By properly exercising their responsibilities, and providing the
advice and perspective that can come only from directors, the
board can help increase stockholder value, reduce tension within
the organization, and mitigate litigation risk.
Jeffrey S. Phillips is a Managing Director in the Valuation & Financial
Opinions Group at Stout Risius Ross (SRR) where he leads
SRR’s Transaction Advisory Services practice. He has extensive
experience in providing transaction and valuation opinions
involving Fortune 500 and middle market companies. Mr. Phillips
can be reached at 703.848.4955 or jphillips@srr.com.
Michael J. Levitin, Esq. is a Partner in WilmerHale’s corporate
practice group, with extensive M&A experience. He is also an
adjunct professor at Georgetown University Law Center, where
he teaches a seminar on international mergers and acquisitions.
Mr. Levitin can be reached at 202.663.6163 or michael.levitin@
wilmerhale.com.
Thomas J. Hope, CFA Resources for Corporate,
M&A, and Securities Attorneys
thope@srr.com
646.807.4223
Our services include:
■ Mergers & acquisitions advisory
■ Private market financing (debt and equity)
■ Corporate strategic alternatives and
succession planning
■ Fairness opinions
■ Solvency and capital adequacy opinions
■ Merger exchange ratio determinations
■ Litigation advisory related to:
■ Dissenting shareholder actions
■ Minority oppression actions
■ Shareholder and commercial disputes
■ Post-transaction purchase price disputes
©2010 7 ©2010

10. M&A and Financing
Market Update
Terrel G. Bressler – tbressler@srr.com
David E. West – dwest@srr.com
Market Activity General economic uncertainty and an anemic ■ Greater bank credit availability
recession recovery continue to affect the overall US M&A deal
■ Abundant supplies of private equity capital in the
environment. Clearly, during the first two quarters of 2010 the
financial buyer community
M&A market showed modest improvement from the depths
experienced in the “dark days” of 2009. Both M&A dollar volume ■ Almost $2 trillion of cash on the balance sheets of
and number of deals showed gradual monthly improvement. public strategic buyers
■ Generally improving earnings of potential sellers as they
During the first half of this year most deal market professionals
rolled off “bad” months or quarters of 2009 earnings
were very enthusiastic about the M&A markets’ prospects for
2010. All of the ingredients for an improving deal market seemed ■ Motivated sellers who have
to be in place. been waiting for a liquidity event since late 2008
Overall, the early 2010 deal market
M&A Deals Between $1 Million and $500 Million pipeline, measured anecdotally by new
business proposal activity, appeared
$140 1,000
900 to be filling. However, as of June 2010,
Number of M&A Transactions
M&A Deal Volume ($ billions)
$120
800 the anticipated new deal volume has
$100 700 yet to materialize. In fact, according to
600 Dealogic, early readings of year to date
$80
500 Global M&A deal activity through July
$60 400 2010 were only marginally ahead of the
$40 300 deal flow for the same period last year.
200
$20
100
$0 0
Oct 08
Oct 09
Jul 08
Jul 09
Apr 08
Apr 09
Apr 10
Jan 08
Jan 09
Jan 10
M&A Deal Volume Number of M&A Transactions
Source: Factset
©2010 8 ©2010

11. Economic uncertainty and a lack of visibility for corporate Financing Markets ■ ■ ■
earnings will probably serve to reduce the level of M&A for
the rest of 2010. The credit markets have evidenced significant positive trends
for larger middle market borrowers with a modest easing of
Valuations M&A deal valuations improved modestly from the credit metrics for smaller borrowers, but continue to constrain
valuation trough experienced in 2009. transaction activity. We expect modest, but favorable, progress
in lender and investor appetite
Average U.S. Strategic Middle Market Transaction Multiples for the balance of 2010. We have
seen material improvement in
10.0x 9.5x
8.8x
9.2x pricing for solid borrowers and
9.0x 8.5x 8.4x
7.7x a moderate relaxation in credit
8.0x 7.3x 7.5x 7.5x
7.0x
7.0x
metrics for borrowers with greater
6.0x than $15 million of EBITDA.
5.0x
4.0x Mezzanine investors have begun
3.0x to selectively consider investments
2.0x in cyclical issuers. We believe
1.0x these trends will emerge over the
0.0x
next three to six months.
2003 2004 2005 2006 2007 2008 2009 IH09 2H09 1H10
Source: Thomson Financial Senior Bank Debt Middle market
loan issuance was $33.0 billion
Improvement in the commercial banking sector resulting in a in the second quarter, up 47.3% from the same time period of
greater access to financing, better quality sellers, and increased 2009. The 2010 YTD issuance was $55.4 billion, up 91% from
competition (the law of supply and demand) for the deals have the same time period of 2009. According to Reuters Loan Pricing
helped support valuations. Another factor in these increased Corporation, lenders were more aggressive in seeking loan
valuation multiples may be the increased use of forward or opportunities than in the first quarter of 2010, however, much of
annualized earnings to “price” companies. In many cases, a the lending was attributed to refinancing. For companies with less
company’s trailing 12 month earnings or cash flow was seriously than $15 million of EBITDA, overall market conditions were still
affected by the recession and not a true indicator of a company’s characterized by higher pricing, more conservative structures,
“steady state” earnings potential. In the current environment, lower leverage multiples, and tighter covenants than for companies
forward, or annualized earnings, and cash flow measures were with more than $15 million of EBITDA. Although the credit markets
used instead as this was a better proxy for a company’s steady began to open up in the first half of 2010, we believe issuance will
state earnings potential and its steady state valuation. This resulted still recover at a moderate pace for the remainder of 2010.
in an acceptable value to the seller and
a higher valuation multiple when
compared to the company’s actual Median EV / LTM EBITDA LBO vs. Strategic
trailing earnings.
14.0x
Recent valuation data seems to indicate 12.0x
that strategic buyers paid slightly
10.0x
EV/LTM EBITDA
more than financial buyers for similar
companies. The data indicates that 8.0x
the strategic buyer is now paying on
6.0x
average 0.75x to 1.00x cash flow more
than the financial buyer community. 4.0x
2.0x
Large balances of cash held by
strategic buyers, increased competition 0.0x
for deals, and the desire by strategic
buyers to increase revenue and Number of Trailing Quarters from 2Q 2010
Number of Trailing Quarters from 2Q 2010
earnings growth for the next economic
LBO Strategic
upturn all contributed to increased Source: Capital IQ
aggressiveness from the strategic
buyer community.
©2010 9 ©2010

12. Pricing and terms for a particular borrower are a function of specific High Yield Bonds High yield debt issuance for 2010 YTD increased
facts and circumstances. However, in general, we are seeing the substantially versus 2009 YTD volume. Issuance totaled $106.2
following broad bank lending market conditions: billion for 2010 YTD, nearly doubling the $58.3 billion in volume
completed in 2009 of the same time period.
Over $15 million in EBITDA Borrowers
(club or non-broadly syndicated deals) Private Equity According to Buyouts, there were 266 control-stake
private equity transactions in the first half of 2010, an increase
■ 3x to 4x senior debt / EBITDA and 4x to 5x total debt / of 13.7% versus the 234 transactions completed in the first half
EBITDA levels of 2009. Total reported deal value for the first half of 2010 was
■ Cash flow pricing of: (i) 1% to 2% up front; (ii) 350 to $21.8 billion, an increase of 118.0% from the total of the same time
600 bps credit spread; and (iii) 0% to 1% LIBOR floor period of 2009. The moderate resurgence in fundraising in 2010
coupled with the low level of transaction activity in 2009 allows
■ Asset based pricing of: (i) 0.25% to 0.50% up front;
private equity firms to have a healthy amount of capital to put to
(ii) 175 to 350 bps credit spread; and (iii) generally no
work for the remainder 2010.
LIBOR floor
Under $10 million in EBITDA Borrowers Initial Public Offerings The U.S. IPO market has been weak since
(club or non-broadly syndicated deals) early 2008, but began to show signs of recovery in the first half of
2010. According to Bloomberg, 83 IPOs were priced in the first
■ 2.5x to 3.5x senior debt / EBITDA and 3.0 to 4.0x total half of 2010 versus 24 IPOs in the first half of 2009. Total proceeds
debt / EBITDA levels came in at $12.87 billion in the first half of 2010, up 278.5% from
■ Cash flow pricing of: (i) 1.5% to 2.5% up front; (ii) 400 to $3.40 billion raised in the first half of 2009.
700 bps credit spread; and (iii) 1% to 2% LIBOR floor
Economic Conditions ■ ■ ■
■ Asset based pricing of: (i) 0.50% to 1.00% up front;
(ii) 225 to 400 bps credit spread; and (iii) no LIBOR floor ■ The Fed continues to keep interest rates at historic lows
to a 1% LIBOR floor
■ The Fed continues to keep liquidity in the financial system
by maintaining the size of its investment in treasuries and
Private Placements Traditional private placement volume for the
mortgage backed securities
first half of 2010 came in at $20.5 billion, up 46.3% from the same
time period of 2009 total of $14.0 billion. Many issues were upsized ■ Unemployment remains stubbornly high at 9.5% with little
with circled spreads tightening from initial price talk. prospect of declining anytime soon
Mezzanine Since the beginning of 2010, nearly $4.4 billion of
■ There has been little growth in private sector
employment
mezzanine funds were raised, showing promise from the dismal
$3.0 billion raised in all of 2009. All-in return requirements are The US economy continues to struggle and there is growing
highly sensitive to company size and exposure to cyclical factors. evidence that the recovery may actually be slowing and is “more
Generally speaking, non-cyclical to modestly cyclical issuers with modest” than anticipated. The economy does not appear to have
$15 million of EBITDA are seeing all-in investor return requirements achieved the “Escape Velocity” that Larry Summers, the Obama
of 14% to 18% with a selective return to all-coupon structures. Administration’s Chief Economist, referred to in April 2010 to move
Issuers with between $10 million and $15 million of EBITDA the economy back on a strong growth track.
are seeing all-in return requirements of 16% to 20% with some
upside component. For companies in the $5 million to $10 million While many large public companies have posted strong second
EBITDA range, investor return requirements range from 18% to quarter results in July, there is still a lack of business confidence in
22% including an upside component and for companies with less the direction of the economy which is preventing many companies
than $5 million of EBITDA, the range is 20% to 24%, including an from expanding their factories and adding jobs. This is reflected in
upside component. The National Federation of Independent Businesses Index of Small
Business Optimism which fell to 88.1 in July from 89.0 in June, the
Investment Grade Bonds According to Thomson Reuters, second monthly decline this year.
investment grade volume for 2010 YTD was $318.9 billion, a
16.9% decrease from the $383.8 billion issued during the same Consumers are similarly worried and have pulled back on spending
period in 2009. The number of issues decreased 7.6% to 339 in and have increased their savings rate. After three consecutive
2010 YTD from 367 in 2009 during the same time period. Activity is months of increases The Conference Board Consumer Confidence
expected to increase as many issuers take advantage of historically Index declined to 52.9 in June, down sharply from 62.7 in May.
low yield levels. Until there is greater economic certainty for both businesses
and consumers we may be in a low to no growth economy for
some time.
©2010 10 ©2010

13. Conclusion ■ ■ ■
Deals are being consummated despite the uncertain economic
environment. Creativity and a carefully thought out strategy
are essential to achieving a well executed M&A or Financing
transaction. Uncertainty is unlikely to materially diminish near
term, however, the November elections may provide some clarity
and stability with respect to economic and regulatory direction.
Terrel G. Bressler is a Managing Director in the Investment Banking
Group at Stout Risius Ross (SRR). He has originated a wide variety
of M&A and capital raising assignments and has assisted numerous
middle market companies and their shareholders with mergers,
acquisitions, raising debt, mezzanine and equity capital, and other
investment banking transactions. Mr. Bressler can be reached at
312.752.3359 or tbressler@srr.com.
David E. West is a Managing Director in the Investment Banking
Group at Stout Risius Ross (SRR). He has a broad range of
transaction experience involving primarily middle market
companies, including mergers and acquisitions advisory, raising
debt, mezzanine and equity capital and other investment banking
transactions. Mr. West can be reached at 312.752.3306 or
dwest@srr.com.
©2010 11 ©2010

14. Guest Article
The Benefits of
Mezzanine Financing
for Middle Market
Companies
Patrick Rond – prond@kppinvest.com
Nicholas Stone – nicks@kppinvest.com
Key Principal Partners
Recent market conditions have re-established mezzanine ■ Subordinated debt is comprised of a current interest
financing’s appeal as a tax-efficient source of long-term capital. coupon, payment in kind (PIK), and warrants.
With the reduction of traditional senior bank credit and the ■ Preferred equity is junior to subordinated debt and
reluctance of banks to lend under the lenient terms and low viewed as equity from those more senior in the
rates offered over much of the last decade, mezzanine is one of capital structure.
the more effective vehicles for owners of closely held private
companies interested in facilitating liquidity for wealth
diversification or succession purposes, pursuing acquisitions, or Mezzanine Capital: Example Capital Structure
funding organic growth.
Mezzanine Financing and
Common Equity
Capital Structure ■ ■ ■
Mezzanine, or junior capital, financing is the portion of a
company’s capital that sits between senior debt and common Preferred Equity
Return
Mezzanine Capital
equity in the form of subordinated debt, preferred equity, or or Junior Capital
Subordinated Debt
some combination of these two securities. While mezzanine
financing can be structured in a number of ways, common
characteristics include:
Senior Debt
■ Subordinate to senior debt in terms of payment priority,
mezzanine is senior to common equity.
■ Unlike bank loans, junior capital is typically unsecured
and commands a higher yield than senior debt.
Subordinated debt characteristically has a fixed interest rate or
■ There is no principal amortization. coupon as well as a small equity component, and typical returns
■ A portion of the return is fixed making this class of range from the mid-to-high teens. Preferred equity returns are
security less dilutive than common equity. naturally higher than subordinated debt and often include a fixed
return coupled with equity or equity-like instruments.
©2010 12 ©2010

15. Common Uses for Mezzanine Finance ■ ■ ■
Ownership Transition Example
Shareholder Liquidity
and Intergenerational Transfer ■ 5x
Active Shareholders Minority shareholders boost
Active Shareholders
/ Management Team equity from 40% to 85%
Reallocating assets to diversify an owner’s holdings / Management Team
4x
Ownership = 40% through a leveraged Ownership > 85%
recapitalization
Entrepreneurs and family held businesses often reinvest free
Multiple of EBITDA
cash flow back into their companies over time and, as a 3x
result, shareholders find that a majority of their personal net Mezzanine Capital Mezzanine Capital
1.5x EBITDA 1.5x EBITDA
worth is encumbered by the business. Mezzanine financing Ownership < 15% Ownership < 15%
2x
can be an effective way to fund a one-time dividend, Inactive Shareholder
Ownership = 60%
providing liquidity for this past reinvestment and diversifying
Senior Debt Senior Debt
an owner’s holdings. 1x 2.0x EBITDA 2.0x EBITDA
While many senior lenders, even today, are open to lending
Pre-Transaction Leveraged Recapitalization Post-Transaction
against collateral to provide for a shareholder dividend, rarely is
**Please note that the example above is hypothetical and is intended for illustration purposes only**
it without restrictions or personal guarantees. Once mezzanine
financing has been introduced as part of the capital structure,
senior lenders often accept the junior capital as a long-term The Ownership Transition Example illustrates how this type of
equity oriented security making it possible for the owner to avoid transaction is affected. Assuming an initial debt-free balance
the personal guarantee requirement. sheet and total leverage of 3.5x earnings before interest, taxes,
depreciation, and amortization (“EBITDA”) at close, the inactive
This small but significant change in the capital structure provides shareholder receives a 5.8x EBITDA valuation for his or her 60%
owners with an attractive way to leverage a company, take a ownership position, leaving the active shareholders or management
meaningful dividend, and mitigate risk. The capital received team with an ownership position equal to or exceeding 85%.
by owners can be used to diversify their holdings and increase
allocations in other investments, establish a family trust or other Since mezzanine debt is less dilutive and less expensive than
tax advantageous structure to prepare for future estate needs, equity, it allows the remaining shareholders to increase their
and most importantly, safeguard the wealth they have created original equity stake and naturally leverage their return.
by establishing assets unrelated to the company, its creditors, or
Distributions prior to the scheduled increases in
traditional market risks inherent in the business.
long-term capital gains
Ownership transition
There is a current timing wrinkle that encourages owners to move
When shareholders in a privately held company are interested quickly if they are considering taking capital out of a business. As
in personal liquidity, most view their only option as a sale of the part of the 2005 Tax Increase Prevention and Reconciliation Act,
company. While a shareholder seeking liquidity may consider the which extended the terms of the original 2003 Tax Act until the
option of selling his or her equity to other existing shareholders end of 2010, long-term capital gains tax rates were reduced from
or the management team, rarely do either of these latter groups 20% to 15% for the highest tax brackets. Under the federal budget
have the personal assets available to finance the purchase of proposed for 2011, these tax cuts will be allowed to expire and the
the company. Mezzanine financing can facilitate the transition original, higher rates will prevail.
of ownership in these scenarios without the need for seller
Additionally, the recently passed health care reform legislation calls
financing or other expensive equity alternatives. In order to affect
for another tax on investment income of 3.8% for couples earning
this type of transaction:
more than $250,000 in annual income beginning in 2013, bringing
■ The owner agrees to sell his or her portion of the the effective rate to 23.8%.
business to family members, other existing shareholders,
Therefore, owners planning to take capital out of a business may
or the management team.
want to move quickly to avoid these tax consequences. Since a
■ The company borrows a combination of senior debt and sale of the company to a strategic buyer or institutional investor
mezzanine capital. can take three to nine months, a dividend recapitalization utilizing
■ The capital proceeds created by the combination of mezzanine financing may be one of the few options available to
senior debt and mezzanine are then used to buy out the shareholders interested in liquidity prior to the end of 2010.
inactive shareholder at a fair market value, leaving active
shareholders or the management team as the company’s
controlling shareholders.
©2010 13 ©2010

16. Acquisition Financing ■ The Acquisition Finance Illustration compares two strategies,
a commitment to the status quo versus expansion through
For companies looking to grow through acquisition, the last few acquisition. Each case assumes a sale of the company at
years have presented an unusual confluence of circumstances: the end of the fifth year. While no credit is given for post
acquisition efficiencies or economies of scale in the Acquisition
■ Many companies were adversely affected by the scenario, the valuations at T0, inclusive of the add-on acquisition,
economic slump, which resulted in dampened profitability
are assumed at 6.0x EBITDA, and the exit valuations at T5
and naturally depressed valuations. This chain of events
are assumed at 7.0x EBITDA.
has many equity owners, once with unrealistic valuation
expectations, now willing to consider a liquidity event with By using mezzanine capital to expand through acquisition, the
reasonable terms. equity value in year five is 18% higher than in the status quo case,
■ Due to a lack of transaction activity since mid-2008 underscoring the net benefit to the common equity holders. This
coupled with the number of aging shareholders searching further illustrates that mezzanine capital is a cost-effective solution
for ways to exit their businesses, the number of for expansion-minded companies seeking alternatives to raising
companies that will be sold over the next few years is outside equity.
expected to swell.
Growth Capital ■
■ Financing for acquisitions made by privately held
companies has been especially tight. As evidenced over Mezzanine capital can also be particularly suitable for companies
the past 24 months, banks have pulled back from M&A that have established themselves but lack access to commercial
lending, and the covenants for loans that are made have paper or the global funding sources of large corporations. The
become far more rigid. This credit tightening is most advantages of mezzanine to finance capital expenditures to
pronounced for lower middle market companies. support increased capacity, research and development, or new
market expansion are the same as for other applications: it’s
In summary, while more accretive acquisitions will likely be available cheaper than equity and offers more flexible terms and covenants
to strategic buyers at reasonable prices, bank lending capacity to than senior debt.
complete these acquisitions has been significantly constrained
The Benefits of Mezzanine Capital ■ ■ ■
and appears to change day to day.
Non-amortizing, resulting in improved cash flows
Owners are then faced with foregoing the acquisition or
raising outside capital to support the theoretical “gap” in the Senior debt usually has a highly structured amortization schedule
capital structure. with relatively short maturities, often no more than three years
for privately held companies. Most junior capital
securities have longer maturities, usually five to
Acquisition Finance Illustration seven years, with the principal paid at maturity.
(MM) Because mezzanine financing does not require
All T 0 assets valued at 6.0x EBITDA. TEV: $134.0
130 All T 5 assets valued at 7.0x EBITDA. amortization during the term of the debt,
120
EBITDA growth of 5% per year. companies are able to use the increased cash
Equity Value: $122
No benefit was assumed for post acquisition efficiencies.
flow to: (i) pay down senior debt, (ii) invest
110
in working capital, product development, or
TEV: $103.2
100 Cash (Net of Debt): other expansion, or (iii) accumulate the cash on
90
$13.8 TEV: $90 the balance sheet to take advantage of future
Equity Value: $45M unforeseen opportunities.
80
Equity Value: $89.3 Source of flexible long-term capital
70
TEV: $60
60
Base EBITDA: $10
As a rule, mezzanine financing offers significantly
50 Equity Value: $35 Total EBITDA: $15 more flexibility in coupon structure, terms,
and amortization than banks and senior debt
40
Mezzanine providers. A mezzanine investment can easily
30 1.5x EBITDA
be tailored to a company’s particular financial
20 EBITDA: $10 EBITDA: 12.8M EBITDA: $19.2 situation and concerns. Unlike a traditional bank
Senior Debt
loan, mezzanine capital is unsecured and thus,
10 Debt: 1.5x EBITDA 1.5x EBITDA
Debt: 0.6x EBITDA
requires no readily marketable collateral. Because
T0 Status Quo T5 T0 Acquisition T5 mezzanine investors are more equity oriented than
**Please note that the example above is hypothetical and is intended for illustration purposes only**
©2010
14 ©2010

17. senior lenders, they tend to be more amenable to customizing their Mezzanine Financing – Filling a Niche for
investment to meet the borrower’s financial, operating, and cash Middle-Market Companies ■ ■ ■
flow needs.
According to Thomson Reuters, over $25 billion has been raised
A less expensive, tax-advantageous alternative to equity by limited partnership mezzanine funds since 2008, evidence
that the mezzanine financing market is mature, well developed,
Mezzanine capital, when utilized in conjunction with senior debt,
and accessible for issuers. Again, no single type of financing is
reduces the amount of equity required in a business. Since
appropriate for every instance. There are cases where mezzanine
common equity is the most expensive form of capital and is not tax
financing may not be available to a company, but for well-managed
deductible, mezzanine debt can create a more efficient structure
companies with strong cash flow and good business prospects,
that lowers the after-tax cost of capital, is less dilutive than equity
mezzanine financing can be a smart solution for a variety of
financing, and enhances the return on equity.
liquidity or expansion needs.
Mezzanine financing offers other benefits to companies focused
Patrick Rond and Nicholas Stone are investment professionals
on optimizing their capital structures and expanding access to
at Key Principal Partners Corp., a $1.2 billion private equity
funding. Since mezzanine capital providers take a long-term view
and mezzanine fund with offices in Cleveland, Greenwich, and
of a company, banks may look at firms with institutional investors
San Francisco. KPP makes investments of $10 - $40 million per
in a more positive way, extending credit with more attractive
transaction and has the flexibility to structure its investments
terms and relinquishing the need for personal guarantees.
as subordinated debt, preferred stock, and common equity.
Additionally, mezzanine investors help diversify a company’s
Mr. Rond can be contacted at 216.828.8138 or prond@kppinvest.
funding relationships, reducing dependence on any one investor
com, and Mr. Stone can be contacted at 415.439.5371 or nicks@
or lender.
kppinvest.com (www.keyprincipalpartners.com).
Considerations in Mezzanine Financing ■ ■ ■
Of course, no single type of funding is perfect for every situation,
and borrowers need to make sure that the lenders and terms
are right for them. In addition, there may be certain business
or transaction characteristics which make it difficult to utilize
mezzanine financing. These attributes may include but are not
limited to the following:
■ High customer concentration
■ Capital expenditure intensive business
■ Lack of management
■ Commodity-like products or services
■ Cyclicality resulting in volatile cash flow
■ A current debt to EBITDA ratio close to or exceeding the
market value of the company
©2010 15 ©2010

18. Dividend Recaps:
Trends and the
Importance of
Solvency Opinions
Aziz El-Tahch, CFA – aeltahch@srr.com
After peaking in 2007, private equity transactional activity crashed Dividend Recaps ■ ■ ■
alongside the credit markets in 2008 and 2009. According
to PitchBook, a research firm, the total amount of private Simply put, a dividend recap is the process of using borrowed
equity capital invested in the United States declined from over money to issue a special dividend to a company’s private equity
$600 billion in 2007 to approximately $200 billion in 2008 and investors. Private equity firms benefit from this type of transaction
$60 billion in 2009.1 for numerous reasons:
In late 2009, however, private equity activity ascended from its ■ A dividend recap enables the private equity firm to
mid-2009 nadir. In the fourth quarter 2009 and the first half 2010, achieve partial liquidity earlier than an initial public
there were 985 reported deals worth a combined $80 billion – offering or the outright sale of a portfolio company,
a significant improvement from the 889 deals worth a combined which increases the private equity company’s internal
$33 billion in the first three quarters of 2009.2 Not surprisingly, the rate of return on the investment.
increase in private equity activity coincided with an improvement ■ A dividend recap does not dilute the private equity firm’s
in the lending environment. Average lending multiples for private ownership of a portfolio company, which allows the
equity acquisitions increased from 3.9x EBITDA in the fourth private equity company to maintain operational control
quarter 2009 to 4.1x in the first quarter 2010, with some banks and capture the full benefit of future growth.
even lending up to 5.0x EBITDA.3
■ A dividend recap enables the portfolio company
The improvement in the credit markets in late 2009 also led to to benefit from the “tax shield” attributable to the
the revival of a seemingly forgotten vestige of private equity’s tax deductibility of interest payments on the
heyday – leveraged dividend recapitalization transactions, more newly-issued debt.
commonly known as “dividend recaps.”
1
Private Equity Investment Trends – 3Q 2010 (PitchBook, 2010).
2
Ibid.
3
Private Equity Investment Trends – 2Q 2010 (PitchBook, 2010).
©2010 16 ©2010