Professor John Paglia, lead researcher for the Pepperdine Private Capital Market Project, spoke at the annual meeting of the National Association of Small Business Investment Companies (NASBIC) in Palm Beach, Florida. He addressed the National Summit for Lower Middle Market Funds, the premier networking event for lower middle market private equity funds, independent sponsors, investors and service providers. http://bschool.pepperdine.edu/privatecapital

1. The State of the Middle Market Todayy
National Summit for Middle Market Funds
October 25, 2010
John K Paglia Senior ResearcherJohn K. Paglia, Senior Researcher,
Denney Academic Chair,
and Associate Professor of Finance

2. Agenda
• Overview of Pepperdine Private Capital Markets
Project
• Insights from Various Segments• Insights from Various Segments
– Banks
– Mezzanine
– Private Equityq y
• The Road Ahead: 12 Month Outlook
• Panel Discussion
– Tom Hiatt, Centerfield Capital Partnerso att, Ce te e d Cap ta a t e s
– Preston Walsh, PNC Mezzanine Capital
– Rob Zielinski, Riordan, Lewis & Haden Equity Partners
– Greg Greenburg, Altus Capital Partners
• Questions and Answers

3. • What is cost of capital for privately-held businesses?
Pepperdine Private Capital Markets Project
p p y
• Project launched in 2007; first semi-annual report published in
July 2009
• Survey 12 segments including limited partners, privately-held
business owners, capital providers, intermediaries, and
appraisers
• Typical survey asks about firm profile, behavior, historical
returns expected returns view of next 12 monthsreturns, expected returns, view of next 12 months
• Capital providers last surveyed in September 2010. Report to
be available mid-November at
http://bschool.pepperdine.edu/privatecapitalp p pp p p

4. How Are Investments Evaluated in the
90.0%
100.0%
85%
82%
89% 93%
Private Markets?
50 0%
60.0%
70.0%
80.0% 76%
49%
66%
20.0%
30.0%
40.0%
50.0%
15% 21%
11%
0.0%
10.0%
Payback Internal Rate
of Return
(IRR)
Discounted
Cash Flow
(DCF)
Multiple
Analysis
Market
Analysis
Option
Analysis
Decision trees Simulation
Analysis (i.e.,
Monte Carlo
Scenario
Analysis
Gut feel
(IRR) (DCF) Monte Carlo
methods)Angel VC PE Mezz Business Average
Source: Pepperdine Private Capital Markets Project Survey Report, February 2010

5. Factors
(39‐75%)
VCs
(25‐40%)
Angels
(30‐60%)
Banks
ABLs
(4‐18%)
Mezz
(18‐22%)
PEGs
(20‐30%)
(3‐6%)
( )

6. Banks: Today vs 6 Months Ago
• No increase in business confidence/conditions
Banks: Today vs. 6-Months Ago
• Demand for loans up but increases in underwriting
standards and covenant tightness
• Slight decline in standard advance rates and increased• Slight decline in standard advance rates and increased
focus on collateral as backup means of payment
• Increases in senior and total leverage multiples

7. Banks: Loan Sizes and Motivations
35%
34.9% 34.9%
Largest concentrations of
10%
15%
20%
25%
30%
35%
14.3%
27.0% 27.0%
19.0%
14.3%
Largest concentrations of
loan sizes were between $1
million and $50 million
38 1%
12.2%
2.5% Refinancing
Management buy‐out
0%
5%
10%
< $1M $1M ‐
$5M
$5M ‐
$10M
$10M ‐
$25M
$25M ‐
$50M
$50M ‐
$100M
$100M ‐
$500M
> $500M
1.6%
38.1%
10.0%
14.7%
1.1%
14.7%
Financing growth
Chapter 11 workout
Acquisition loan
Debtor‐in‐possession
Working capital fluctuations
Refinancing accounted for nearly
40% of all lending activity followed
by acquisitions (15%)
4.3%
2.4%
g p
Equipment or building
Other
by acquisitions (15%)

8. Banks: Senior Leverage Multiples
Business Services 1st Quartile Median 3rd Quartile
$1M 1.2 1.2 1.9
$5M 2.5 2.5 3.0
Approximately 1.2X –
2.5X under $10M in
$10M 2.5 2.5 3.0
$25M 2.5 3.0 3.0
$50M 2.6 3.0 3.0
$100M 3.1 3.3 3.4
EBITDA; 3X and above
greater than $10M
Manufacturing 1st Quartile Median 3rd Quartile
$1M 1.3 1.3 2.0
$5M 2.1 2.5 3.0
$10M 2 4 2 5 3 0
Approximately 1.3X –
2.5X under $10M in
EBITDA 3X and above$10M 2.4 2.5 3.0
$25M 2.6 3.0 3.0
$50M 2.5 3.0 3.0
$100M 2.3 3.0 3.2
EBITDA; 3X and above
greater than $10M
Generally about ½ turn higher except in $1M (down from 1 5)Generally about ½ turn higher except in $1M (down from 1.5)

9. Banks: All in Rates on Cash Flow Loans
Cash flow loan all‐in‐Rate (%)
$1 million
1st Quartile 5.4
Median 6.5
3rd Quartile 7 1
Median all‐in‐rates from 5%
to 6.5% depending on size;
3rd Quartile 7.1
$5 million
1st Quartile 5.0
Median 5.5
3rd Quartile 6.0
$10 illi
some as low as 3.5%
Rates correspond to loan
terms of 36 months (median)$10 million
1st Quartile 4.5
Median 5.5
3rd Quartile 7.0
$25 million
1 t Q til 3 8
terms of 36 months (median)
within range of 30 – 60
months (1st and 3rd quartile)
1st Quartile 3.8
Median 5.5
3rd Quartile 7.2
$50 million
1st Quartile 3.5
M di 5 0
Rates generally flat except
up 50 b.p. for $1 million
Median 5.0
3rd Quartile 7.4

10. Banks: The Next 12 Months
• Sharp increase in demand for loans
Banks: The Next 12 Months
• Underwriting standards slightly more stringent
while credit quality of borrowers continues to
improveimprove
• Further increases in senior/total leverage multiples
• Collateral remains in focus
• See confidence and conditions improving

11. Mezzanine: Today vs 6 Months Ago
• Demand for business investment up
Mezzanine: Today vs. 6-Months Ago
• Increases in investment standards, credit quality of
borrowers, appetite for risk
• Deal senior leverage and total leverage multiples up• Deal, senior leverage, and total leverage multiples up
• Time to exit investments slightly longer

12. Mezzanine: Current Activity
Nearly 70% of respondents reported
making a deal in last 6 months;
approximately 30% reported no
t ti
30%
4%
5% 9%
2% 4% 2% 2% 0
1
2
3
4
transactions
47.7% 53.8%
24.6%
12 3%
30.0%
40.0%
50.0%
60.0%
14%
14%
14% 5
6
8
10
11
16 or more
0% 4% Refinancing
1.5%
12.3%
6.2% 3.1%
0.0%
10.0%
20.0%
25%
21%
14%
28%
7%
Refinancing
Management buy‐out
Financing growth
Chapter 11 workout
Acquisition loan
Most investments in $1 million to $25
million range; Acquisition loan investments
accounted for 28% of activity, followed by
14%
1%
Debtor‐in‐possession
Dividend recap
Other
refinancing (25%) and MBO (21%)

13. Mezzanine: Pricing
$1M $5M $10M $25M
1st Q 12 4% 12 0% 12 3% 12 0%
$1M $5M $10M $25M
1st Q 13 3% 12 0% 12 0% 11 8%
Sponsor Transactions Non‐Sponsor Transactions
Interest Rate (%)
1st Q 12.4% 12.0% 12.3% 12.0%
Median 13.3% 12.8% 13.0% 12.0%
3rd Q 13.6% 13.0% 13.0% 12.0%
1st Q 13.3% 12.0% 12.0% 11.8%
Median 14.0% 14.0% 12.0% 12.0%
3rd Q 14.0% 14.0% 13.0% 12.8%
PIK (%)
$1M $5M $10M $25M
1st Q 3.3% 2.0% 2.0% 2.6%
Median 3.5% 3.0% 2.0% 2.9%
3rd Q 3.8% 4.0% 3.0% 3.0%
$1M $5M $10M $25M
1st Q 2.0% 1.0% 2.0% 2.5%
Median 2.0% 2.0% 2.0% 3.0%
3rd Q 2.0% 2.0% 2.8% 3.0%
Total
Returns $1M $5M $10M $25M
1st Q 18.0% 17.5% 17.3% 17.9%
Median 20 0% 20 0% 18 9% 18 5%
Total
Returns $1M $5M $10M $25M
1st Q 23.0% 22.0% 20.0% 17.8%
Median 24 0% 22 0% 20 0% 18 0%
Total Returns (%)
Median 20.0% 20.0% 18.9% 18.5%
3rd Q 22.0% 22.3% 20.0% 19.0%
Median 24.0% 22.0% 20.0% 18.0%
3rd Q 24.5% 24.0% 21.3% 18.5%

14. Mezzanine: Total Leverage and Time to ExitMezzanine: Total Leverage and Time to Exit
Total Leverage Ratios (x EBITDA)
$1M $5M $10M $25M
1st Q 2.9 3.5 3.5 4.4
Median 3.5 3.5 4.0 4.8
3rd Q 4.1 4.0 4.0 5.0
Represents additional 1 – 2 turns of
EBITDA (after senior), increasing with
size; relatively flat from 6 months ago
$25M f 4 5X
$1M $5M $10M $25M
except $25M up from 4.5X
Time to Exit (Months)
$ $ $ $
1st Q 36 48 48 33
Median 48 54 60 36
3rd Q 63 60 60 42
Looking to exit in 3‐5 years

15. Mezzanine Investments: Next 12 Months
5%
2% 2%
11%
2%
4% 2%
5%
7%
4%
0
1
2
3
4
5
Largest concentration of responses
indicate plan for four transactions in
( )
29%
13%
14%
5
6
7
8
9
10
12
next 12 months (29%); 56% are
planning between four and six
6.0% 1.4%
0.7%4.2% 1.4%
0.4%1.2%
1.4%2.8% 6.2% Consumer services
Restaurant
Healthcare
Life sciences
12
16 or more
Business services (25.4%),
12.2% 3.1%
2.4%
25.4%21.5%
9.1%
0.8%
Life sciences
Retail
Real estate
Business services
Manufacturing
Wholesale and distribution
Finance, insurance, and related
Information and technology
M di d t t i t
manufacturing (21.5%), and
healthcare (12.2%) look to be areas
targeted for investment;
manufacturing down from 27 8% Media and entertainment
Agriculture and mining
Engineering and construction
Transportation
Oil, gas, and other utilities
manufacturing down from 27.8%

16. Mezzanine: A View to the Next 12 Months
• See increases in demand for business investment credit
Mezzanine: A View to the Next 12 Months
See increases in demand for business investment, credit
quality of borrowers up, increasing appetite for risk, and
investment standards stabilizing
• Deal, senior leverage, total leverage multiples increasing
further
• See size of industry increasing• See size of industry increasing
• Sees improvement in returns Last 12
months
Next 12
months
1st Quartile 7.3% 12.0%
di % %Median 15.0% 18.0%
3rd Quartile 19.3% 22.0%

17. P i t E it T d 6 M th APrivate Equity: Today versus 6 Months Ago
• Demand for business investment is up as are investmentDemand for business investment is up, as are investment
standards, appetite for risk, and quality of companies
seeking investment
• Leverage and deal multiples increased; exit times longer
• Increased ability to assess and price risk
• General contraction in size of industry• General contraction in size of industry
• Communication with and power of LPs has increased

18. Private Equity: Current Activity
32.7%6.1%
3.4%
3.4%
1.4%
0.7%
0.7%
1.4%
2.0%
0.7%1.4% 0
1
2
3
Nearly 68% of respondents reported making a
d l i l t 6 th i t l 33%
21.1%
25.2%
4
5
6
7
8
deal in last 6 months; approximately 33%
reported no transactions
9
10
12
16 or more
50 0% 43.5%
10 0%
20.0%
30.0%
40.0%
50.0%
3 1%
25.9%
30.6%
43.5%
31.6%
21.8%
10.4%
4.7%
The largest concentration of checks
written was in the $10 ‐ $25 million
range (43.5%) followed by $25 ‐ $50
million (31.6%) and $5 ‐ $10 million
0.0%
10.0%
< $1M $1M ‐
$5M
$5M ‐
$10M
$10M ‐
$25M
$25M ‐
$50M
$50M ‐
$100M
$100M ‐
$500M
> $500M
3.1%million (31.6%) and $5 $10 million
(30.6%)

19. Private Equity: Deal Multiples and Equity
C t ib tiContributions
EBITDA 1st Median 3rd Median equity
Quartile Quartile
$1M 38.8% 60.0% 82.5%
$5M 40.0% 60.0% 70.0%
$10M 50.0% 57.5% 61.6%
Median equity
contributions reported
range from a high of 60%
for smaller transactions to
$25M 25.0% 47.5% 60.0%
$50M 21.3% 32.5% 40.0%
$100M 10.0% 20.0% 22.5%
20% for larger companies;
improved > $10 million
EBITDA 1st Quartile Median 3rd QuartileQ Q
$1M 3.9 4.0 5.3
$5M 4.5 5.0 5.7
$10M 5.0 6.0 7.0
Deal multiples range from a
median of 4X EBITDA to 7.5X for
transactions with $50 million
EBITDA $25M 5.5 6.0 7.8
$50M 7.5 7.5 8.0
EBITDA

20. Private Equity: Expected Returns and Exit
TiTimes
EBITDA 1st Quartile Median 3rd Quartile
Expected gross annual returns on
$1M 25.0% 30.0% 35.0%
$5M 25.0% 30.0% 30.0%
$10M 24.5% 30.0% 31.3%
new investment range from a
median of 25% for larger
transactions to 30% for smaller
ones
$25M 25.0% 28.0% 30.0%
$50M 22.0% 25.0% 30.0%
ones
EBITDA 1st
Quartile
Median 3rd
QuartileQ Q
$1M 48.0 60.0 60.0
$5M 48.0 60.0 60.0
$10M 36.0 48.0 48.0
$25M 37.0 48.0 60.0
$
Expected exit times range from 48 months
for larger transactions to 60 months for
smaller ones
$50M 48.0 48.0 60.0
$100M 48.0 48.0 48.0

21. Private Equity Investing: Next 12 Monthsq y g
4%
9%4% 8%
1%
2%
1%
2%1%1% 3% 0
1
2
3
4
Nearly 2/3 (64%) are looking to make 2 – 4 investments
in the next year and approximately 12% of those will
be in distressed assets (prior was 17 9%)
Distressed as a % of total # of transactions 12.3%
Distressed as a % of total VALUE of
transactions
10.0%
30%
23%
11% 5
6
7
8
10
12
14
be in distressed assets (prior was 17.9%)
6.0% 1.2%
11.2%
1.8%
2 2%
6.2%
3.3%
1.8%
0.9%
1.6%
1.7% 4.6%
3.6% Consumer services
Restaurant
Healthcare
Life sciences
Retail
Real estate
15
16 or more
Manufacturing (22.7%, from 2.2%
2.3%
16.7%
22.7%
6.3%
6.0%
Real estate
Business services
Manufacturing
Wholesale and distribution
Finance, insurance, and related
Information and technology
Clean / green technology
Media and entertainment
Manufacturing (22.7%, from
25.5%), business services (16.7%),
and healthcare (11.2%, from 8%)
appear to be the targets of nearly
h lf f ll i t t Media and entertainment
Agriculture and mining
Engineering and construction
Transportation
Oil, gas, and other utilities
Other
half of all investments

22. Private Equity: A 12-Month View
• See increases in demand for business investment, standards,
quality of companies seeking investment, increasing appetiteq y p g g pp
for risk
• Greater ability to assess and price risk
D l i l t t l l lti l i i• Deal, senior leverage, total leverage multiples increasing
further
• Communication with and power of LPs increasing furtherp g
• More contraction in size of PE industry
• See improvement in returns Last 12
months
Next 12
months
1st Quartile 18.0% 22.0%
Median 25.0% 27.0%
3rd Quartile 35.5% 35.0%

23. General Survey Insights Across All Segments
• What is the #1 issue facing privately-held businesses today?
– Limited access to capital (40%)
y g g
p ( )
– Government regulations (taxes, healthcare, etc.) (30%)
– Economic environment / uncertainty (20%)
• What is the #1 emerging issue facing privately-held• What is the #1 emerging issue facing privately-held
businesses?
– Tighter government regulations (35%)
Li it d t it l (25%)– Limited access to capital (25%)
– Economic environment / uncertainty (14%)

24. General Survey Insights: Private Equity, Mezzanine,
• What are the significant trends and developments in private
and Venture Capital
What are the significant trends and developments in private
equity?
– Risk aversion / stricter investing requirements (21% mezzanine, 22%
venture capital 17% private equity)venture capital, 17% private equity)
– Businesses facing lower demand / increasing competition / lower
margins (21% mezzanine, 22% venture capital, 17% private equity)
Government regulations (12% mezzanine 14% venture capital 17%– Government regulations (12% mezzanine, 14% venture capital, 17%
private equity)

25. What about the Businesses?
• Compared to six months ago...
– Time to collect receivables is up
Owner compensation is down– Owner compensation is down
– Competitive pressures are up
– CAPEX is flat, as are other expenses
Opportunities for growth are up sharply but– Opportunities for growth are up sharply, but...
– Access to growth capital is down!
• Who can help? LPs say PE (48%) and Mezzanine (33%) offer best
i k/ t t d ff !risk/return tradeoffs!
– PE returns at 17.0%
– Mezz returns at 12.1%
11%
33%
48%
8%
Venture Capital
Mezzanine Investment
Private Equity48% Private Equity
Hedge Fund

26. The Road Ahead
• Economic View
– GDP at 1.1%
P b bilit f d bl di i t 35%– Probability of double-dip recession at 35%
• Industry View
– Mezzanine and private equity favorite asset classes
– Deal flow increasing
– Leverage and deal multiples increasing
• Business View
– Desperate for growth capital
– Many owners still waiting to sell

27. Thank You!
John K. Paglia
Thank You!
John K. Paglia
Associate Professor of Finance
Senior Researcher Pepperdine PrivateSenior Researcher, Pepperdine Private
Capital Markets Project
bschool.pepperdine.edu/privatecapital
john.paglia@pepperdine.edu