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1. Gauging the True Cost
of Private Capital
Survey Report Volume II – Winter/SPRING 2010
An Executive Summary
John K. Paglia, Ph.D., CPA, CFA

2. Unlike their public counterparts, the veil over private capital markets keeps the true
cost of private capital shrouded in mystery. A high percentage of financial professionals
who live and breathe in these shadowy areas of the lending industry, day in and day out,
rely heavily on “gut instinct,” rather than well-defined financial models. Private business
owners also are ill-equipped to weigh investment risk appropriately or have a reasonable
understanding of the rates of return they should expect.
The Pepperdine Private Capital Markets Project is the first comprehensive and simultaneous
investigation of the major private capital market segments. Based on more than 700
questionnaire responses completed in late 2009, the 120-page study seeks to shed light on
how private capital lenders and others view their industry. The study examines the current
attitudes of professionals from five private capital segments: banks, asset-based lenders,
mezzanine lending, private equity and venture capital. Also, new for this report
are findings based on responses from privately-held businesses asking for their opinions
about borrowing, investment expectations, and access to capital.
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3. • Significant declines in percentage of borrowers approved for credit, but also significant declines in
number of loan applications and reduction in credit quality of borrowers applying for credit. However,
those approved on average have better credit quality.
• Average loan sizes declined as the multiples of cash flow, net worth, and standard advance rates declined.
• Delinquency and charge-off rates increased as the number of loans being made in the industy delined.
• Approximately 67% of cash flow based loans were declined over past 6 months, 63% of collateral based,
and 60% of real estate based. Quality of cash flow, debt load, and insufficient collateral were cited as
primary reasons.
• Collateral type or coverage emerged as the most important factor when deciding to approve a loan,
followed by liquidity ratios and debt to cash flow ratios.
• Banks are using more variable rate loans and are relying more on 1-month LIBOR as a reference rate.
• Approximately 75% of bankers believe prime and LIBOR rates will increase over the next 12 months.
• Refinancing is the primary motivation for loans followed by acquisitions and then working capital.
Banks
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4. • Significant declines in percentage of borrowers approved for credit, but also significant declines in
number of loan applications.
• Delinquency and charge-off rates increased as the number of loans being made in the industy declined.
• Approximately 69% of receivables based loan applications were declined over past 6 months, 74% of
inventory- based, 71% of equipment, and 69% of real estate based. Insufficient collateral, debt load,
and quality of earnings were cited as primary reasons.
• Refinancing is the primary motivation for obtaining the loan followed by financing growth and
then acquisitions.
• All-in rates for working capital loans are widely dispersed and have an interquartile range between
5% and 20%. Smaller borrowers will pay higher rates.
• Receiving larger numbers of business plans and making more investments although appetite
for risk is less. This is reflected in multiples of cash flow lent (decreased) and size of interest rate
spreads (increased). Futhermore, financial covenants are more numerous and tighter on average.
The increased demand for mezzanine financing has allowed funds to increase warrant coverage
(equity participation).
• The size of the mezzanine finance industry has grown during the last 6 months. This is the
only private capital market segment that reports an increase in size. Mezzanine finance is the
beneficiary of curtailed lending at banks and asset based lenders.
• Mezzanine funds have investment concentrations in the service, manufacturing, and
distribution areas of the economy.
• Refinancings and management buyouts account for over half of financings.
• Deals that contain both interest and warrant return elements have increased from 55% to 70%.
• The median coupon interest rate on deals is 14% and over half have payment in kind provisions.
Approximately 65% of respondents report making deals with warrants attached. These warrants,
comprising approximately 5% of the investee company equity, are expected to produce a median
return of 8%.
• Funds are looking to significantly increase the number of investments over the next 12 months
and are targeting service, manufacturing, distribution, and healthcare.
Asset Based Lenders
Mezzanine Funds
3

5. • Firms have witnessed declines in both leverage and deal multiples while their appetite for risk
has also declined. Furthermore, the time to exit deals has increased.
• The size of the PE industry has decreased over the past 6 months.
• The prospects for raising additional funds have declined. Approximately 40% of funds plan to
raise money in the next 12 months.
• Most funds are receptive to making minority investments but would only do so with investor
protections. They also apply a 20% discount to pro rata equity value for a general lack of control.
• Funds expect to make greater concentrations of investment in service and manufacturing over
the next 12 months.
• The number of business plans reviewed in order to close a deal increased from 80 to 100.
• More funds report plans to sell their portfolio companies to a public company than was the case
just 6 months ago. Plans for IPO and other PEG sales declined.
• Funds expect a 25% return on new investment but expect to return 20% to limited investors
over the next 12 months. Portfolio companies are providing a drag on current fund returns.
• Current investments are in software (15.8%), medical devices (13.4%), clean technology (12.3%),
biotech (11.6%). Over 36% of investments are in California and are expected to remain relatively
constant over the next year. Clean technology, software, medical devices, and biotech are expected to
lead investment categories over the next year. Hardware is expected to decline from 6.7% to 3.2%.
• VCs report an increase in the number of business plans received as well as the number of high
quality investment prospects, but the number of plans funded as well as the investment sizes
have declined as the industry contracted.
• The expected exit time on investments has increased and percentage of up rounds has declined
over the past 6 months.
• Over half report a decline in fundraising prospects. Just 41% of funds are expected to fundraise
over the next year.
• Funds report applying a 20% discount to equity pro rata value for making minority investments.
• Similar to PE, a larger number of VCs report their intent, with regard to portfolio companies,
to “sell to public company” than previously. The percentage of respondents indicating IPO as
the exit plan declined from 17% to 12%.
• Funds expect a return to limited partners of 15% over the next year, which is a significant increase
from the prior 12 months. New investments are expected to return 38.2% on average while the
majority of expected returns range from 20% to 65%.
Private Equity
Venture Capital
4

6. • Most important factors when borrowing include interest rates, collateral requirements, loan size,
and customer service. Companies are less concerned with location of lender, sophistication of bank,
and length of loan term.
• Nearly 81% of respondents would be willing to pay a premium on their bank loan to escape a
personal guarantee. The majority would pay between 1-3%, but the median response is 2%.
• Businesses expect a 10% return from purchasing a new phone system, 20% for a new computer
system, 25% for expanding a current market niche or entering a new one, and 30% for hiring a
salesperson and acquiring a competitor. A general investment in the business yields a 20% return
expectation.
• Businesses expect a 20% annual return for a passive, minority equity 10-year investment in an
identical business. They place a premium on time as they’d expect 12% for a one-year investment
and 15% for a five-year.
• Businesses report payback thresholds of approximately 1.5 years for hiring a sales person, while
approximately 2 years for a new computer or phone system, 2.5 years for expanding a current
market niche, 2.8 for entering a new niche, and 3.2 for acquiring a competitor.
• Businesses prefer to use external equity to acquire a competitor while siding with personal equity
for general expansion of business.
• Most businesses are seeking financial independence as opposed to maintaining a current lifestyle.
Most seek risk in anticipation of returns. Just 9% prefer the status quo. This risk seeking behavior
appears irrational however. For a fixed expected return, nearly 75% are willing to take a flyer on the
chance to earn more of a return despite a constant expected benefit.
• The majority of businesses appear overly optimistic about their fundraising chances. Nearly 57%
report an ability to obtain a bank loan, while 47% believe they can access private equity and 41%
think VC is a source of funds for which they qualify. Larger companies ($1 million in revenues)
claim the following qualification rates: 72% bank loan, 32% mezzanine financing, 60% private
equity, and 44% venture capital. Smaller companies report the following qualification rates: 43%
bank loan, 12% mezzanine capital, 35% private equity, and 38% venture capital.
• Despite being generally optimistic about prospects for growth, many businesses are struggling.
30% indicate the probability of failure increased over the past six months, 46% report decreased
access to capital, 34% report declines in the number of employees, 38% report declines in the size
of industry, 50% report increases in competitive pressures, 36% report a decline in confidence of
economic growth, 33% report declines in revenues, 22% report declines in pricing.
Privately-Held Businesses
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7. 6

8. 7
With over 99% of companies having fewer than 500 employees, our economy is
dependent upon the success of small businesses. The Pepperdine Private Capital Markets
Project is critical step along the path of understanding and increasing the value of
private companies and our economy. Professionals who work in lending either for
an institution or a specific fund are excellent bellwethers of what is ahead for other
businesses and consumers. Through two survey cycles and published summary reports
per year, lenders, investors and the businesses that depend on them will be able to
make optimal investment and financing decisions, and better determine where the
opportunities to create lasting economic value may be realized.
How may you contribute to this groundbreaking research undertaking?
• Download the full 120-page report
• Review our sponsorship opportunities
• Sign up to complete future surveys
Learn more at bschool.pepperdine.edu/privatecapital

9. Dr. John K. Paglia, Ph.D., MBA, CPA/ABV, CFA, ASA, the Denney Academic Chair
and former Julian Virtue Professor, is an associate professor of finance and senior
researcher of the Pepperdine Private Capital Markets Project. He has over ten
years of University teaching experience in finance, performs business valuations
for privately-held companies, and has testified as an expert on economic damage
and valuation matters. His research has appeared in The Wall Street Journal, USA
Today, Bloomberg, and The New York Times. Dr. Paglia has been published in a
number of journals including The Graziadio Business Report, Banks and Bank
Systems, Bank Accounting and Finance, Risk Management Association Journal,
Journal of Wealth Management, Trusts and Estates, BetterManagement.com,
Accounting World, Institute of Chartered Financial Analysts of India Journal, and
has been presented at domestic and international conferences. He also has been
quoted in Dow Jones Newswires, Yahoo Finance, BusinessWire, VCExperts.com,
PEHub, VentureBeat, Forbes, The San Jose Mercury, The Ventura County Star,
The Pacific Coast Business Times, Men’s Health, and other well-known publications.
Pepperdine Private Capital Markets Project
Graziadio School of Business and Management
Pepperdine University
6100 Center Drive
Los Angeles, CA 90045
ABOUT THE AUTHOR

10. Sponsorship Opportunities
Be a part of the first comprehensive ongoing investigation of private lending and investing behavior across capital markets,
conducted by Pepperdine University’s Graziadio School of Business and Management. Through two survey cycles and
published summary reports per year, businesses have a unique opportunity to align themselves with groundbreaking research
and reach entrepreneurs, business owners, investors and capital providers. The first report in Pepperdine’s private capital
study was downloaded by more than 1,200 industry professionals in 35 countries and produced findings reported in
The Wall Street Journal, The New York Times, Forbes, USA Today, Investment News, VC Experts and other publications.
Benefits of Sponsorship
• Widely publicized visibility and exposure to private capital providers, media, entrepreneurs, private companies
and industry interest groups
• Prominent placement on research Web site and in published reports
• Recognition in materials at speaking engagements and conferences
Contact:
privatecap@pepperdine.edu
Sponsorship Levels
Angel: $25,000
• Prominent placement of sponsor logo and hyperlink on bschool.pepperdine.edu/privatecapital Web site landing page for one year
• Prominent placement of full page color ad in two (2) published reports (sponsor responsible for artwork)
• Three complimentary copies of survey reports, as available, for one year (2 reports)
• Exclusive “first look” access to survey findings prior to publication
• Sponsor acknowledgement for one year in survey announcements and report e-mail promotions to our 1,500 premium subscribers including capital
providers, private companies, professional associations and other industry professionals
• A speech to your organization by lead researcher Dr. John Paglia
• Complimentary tickets to Pepperdine-hosted private capital speaking engagements and events
• Complimentary tickets to the Dean’s Executive Leadership Series
Champion: $10,000
• Prominent placement of sponsor logo and hyperlink on bschool.pepperdine.edu/privatecapital Web site landing page for one year
• Placement of full page color ad in one (1) published report (sponsor responsible for artwork)
• Three complimentary copies of survey report in which ad is placed
• Exclusive “first look” access to survey findings prior to publication
• Sponsor acknowledgement in survey announcements and report e-mail promotions for one (1) survey/reporting cycle
• A speech to your organization by lead researcher Dr. John Paglia
• Complimentary tickets to Pepperdine-hosted private capital speaking engagements and events
• Complimentary tickets to the Dean’s Executive Leadership Series
Hero: $5,000
• Prominent placement of sponsor logo and hyperlink on bschool.pepperdine.edu/privatecapital Web site survey page for one survey cycle
• Placement of half page color ad in one (1) published report (sponsor responsible for artwork)
• Exclusive “first look” access to survey findings prior to publication for one year
• Three complimentary copies of survey report in which ad is placed
Benefactor: $2,500
• Placement of quarter page color ad in one (1) published report (sponsor responsible for artwork)
• Exclusive “first look” access to survey findings prior to publication for one year
• Three complimentary copies of survey report in which ad is placed