1Abraxas Group

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Adjusting to Shifts in the Middle

Market

Deal Professionals’ Changing Value Proposition

July 28, 2016

David JohnsonInterim Executive (CRO, COO, CFO) Value Enhancement, Restructuring and Turnaround Advisor

“Change before you have to.”

‒ Jack Welch

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• David Johnson is a career change agent who has served as an interim manager or financial advisor on over $5 Billion of middle market transactions.

• David has served as an advisor, board member, interim manager, investor and operator at organizations ranging in size from pre-revenue startups to Fortune 500 organizations.

• A value enhancement expert, David has driven radical value creation in dozens of middle market companies, and is a frequent speaker and writer on the topic.

David Johnson

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Email: david@abraxasgp.com

Ph: 312-505-7238

Twitter: @TurnaroundDavid

Middle Market Overview

There are approximately 195,000 Middle Market companies in the U.S.

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Source: U.S. Census Bureau, 2012

112,655

41,378

21,59012,779

4,315 2,404

0

20,000

40,000

60,000

80,000

100,000

120,000

$10 - $25MM $25 - 50MM $50 - 100MM $100 - $250MM $250 - $500MM $500MM - $1B

# o

f C

om

pan

ies

Revenue Range

U.S. Middle Market Population

Middle Market Overview Cont.

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Source: U.S. Census Bureau, 2012

$15.4

$34.8

$69.2

$152.5

$349.8

$695.0

$10 - $25MM

$25 - 50MM

$50 - 100MM

$100 - $250MM

$250 - $500MM

$500MM - $1B

Re

ven

ue

Ran

ge

Average Revenue by Size Range

The average revenue of a Middle Market company is $50.2MM.

Common Knowledge

Common Knowledge: A game theory concept best summed up as “something that everybody knows that everybody knows”

• Today the dominant piece of common knowledge in the Middle Market is that aging business owners will soon sell their companies en masse.

• Common knowledge is not necessarily true, but it often has the force of truth.

• What if this common knowledge is wrong? What if Middle Market business owners now have more options than ever?

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35% of M&A engagements end without a successful deal.

The top reason cited for M&A transaction failure is a valuation gap.

95% of valuation gaps cited were 11% or greater.

Divergent Expectations

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5%

34%

35%

15%

6%6%

Valuation Gap

1 - 10%

11 - 20%

21 - 30%

31 - 40%

41 - 50%

> 50%

Source: 2016 Private Capital Markets Report

Banks

• Risk averse

• Focused on historic performance and collateral

Non-Bank Lenders Equity

• More risk tolerant capital

• Focused on current enterprise value

• Highest risk tolerance

• Focused on future value

Capital Providers

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Cost of Capital

Capital providers across the risk spectrum are eager to deploy capital in the Middle Market.

Each of these sources of capital embodies diverse firms, but all are investing in the ability to source their own deals, independent of deal professionals.

Shifting Landscape

• Savvy business owners, having built successful companies, are unlikely to moderate their price expectations unless forced.

• Abundant sources of capital, managed by entrepreneurial financiers, are aggressively seeking proprietary deal flow.

• There is no longer a shortage of capital in the market, rather, there is a shortage of quality investment opportunities. The source of value creation has shifted.

• In this environment, the core value proposition of deal professionals must shift from execution to value maximization.

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An Ernst & Young study of private equity exits from 2006 – 2012 in North America found that gross PE returns outperformed the market by 5.4x.

The impact of strategic and operational improvement on returns was found to be approximately double the impact of additional leverage.

Drivers of Private Equity Returns

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Market Based Return

Additional Leverage

Strategic & Operational

Improvement

PE Performance

1.0

1.5

2.9 5.4

Source: Ernst & Young

• Managing Complexity

• Deep Network

• Value Creation Insight

Value Proposition

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• Deal Execution

• Broad Network

• Market Insight

Old New

Deal professionals must look to shift their focus toward

longer customer relationships and driving substantial value.

Cycle of Value Creation / Enhancement

Driving Value

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Competitive Advantage

Capital Structure

Team

Strategy

• Aspirational: Why?

• Directional: Where are we going?

• Executable: How do we get there?

Strategy

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A good strategy should be Aspirational, Directional, and Executable.

Deal professionals should be ready to assist in the development of a cohesive strategy and opine on the value creation potential should the company be able to execute on it.

• Sources of Advantage

• How to Bolster / Gain

• Investment Needed

Competitive Advantage

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What are the capabilities / characteristics that will define sustainable advantage?

Deal professionals must be prepared to tap their networks to bring needed subject matter expertise to their clients.

• Alignment of expectations between capital providers and management

• Sufficient financial flexibility to address unanticipated developments

Capital Structure

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What is the optimal capital structure to support the strategy?

Deal professionals can position their clients for sustained value creation by advising on and securing a capital structure optimized for the company’s strategy.

• Executive Team: Leaders with a laser focus on value creation

• Board of Directors: Senior professionals with deep contacts

• Advisors: Subject matter experts to help company realize potential

Team

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Assemble the best team to execute the strategy.

Deal professionals are well positioned to support their client’s efforts in building a robust team capable of executing on a value creation strategy.

Back to the Future

The Middle Market is on the cusp of a shift, and deal professionals who pivot

to the old Goldman Sachs mantra of being “long-term greedy” (i.e. trusted

relationship advisors) will benefit handsomely.

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Case Study: Overview

• In October 2015, a $150MM+ private equity backed company was facing a difficult challenge.

• As a condition of a recent forbearance agreement, the company’s lenders had insisted on the retention of an investment banking firm to run a “dual track” (i.e. sale or refinancing) process.

• There was very real concern that the company, in the early stages of a turnaround, would be sold at a fire-sale price.

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Case Study: Outcome

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$0Equity Value in July 2015

>$70MMEquity Value Increase

11Months of Turnaround

Rather than a fire-sale price, the company’s leadership team (including David Johnson, serving as Interim CFO), drove consistent outperformance, and in partnership with their investment banking

advisor, were able to close on a $100MM refinancing package in advance of debt maturities.

• In choosing the refinancing option, the company’s financial sponsor turned down offers that implied a doubling of enterprise value (>$70MM increase in equity value) over 11 months.

• Not only was radical value created, but all involved (new lenders, financial sponsor, leadership) were in agreement that the company had become a platform for continued value creation.

Key Takeaways

1) Middle Market Dynamics. The common knowledge that the U.S. Middle Market will soon be deluged with forced selling ignores key facets of the market. In a market awash in capital, the scarce commodity is a good investment prospect.

2) Shifting Value Proposition. Middle Market business owners have options, and deal professionals will need to adjust accordingly. In the coming years, deal professionals should position themselves as agents of long-term value creation.

3) Win-Win. This shift, which is a return to the relationship banking of earlier generations, will position deal professionals for more fruitful client relationships, as well as bolster relationships with other advisors.

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