FINAL REPORT - Private Equity Dynamic Conditions

Private Equity Under Dynamic Market Conditions:Portfolio Company Management & Key Deal Terms

In association with

Novem

ber 2009w

ww

.mergerm

arket.com


02 www.mergermarket.com


Foreword 03

Methodology 03

Analysis 04

The Purchase Price Earn-Out: Potential Fuel for Dealmaking 17

Perspectives from an Investment Banker 20

Historical Data 25

About mergermarket 26

Contents



03

Distressed M&A Outlook

www.mergermarket.com

Methodology

Foreword

Welcome to Private Equity Under Dynamic Market Conditions: Portfolio Company Management & Key Deal Terms, published by mergermarket in conjunction with Akin Gump Strauss Hauer & Feld LLP and BMO Capital Markets. This survey highlights emerging trends in private equity portfolio management and its professionals’ usage of transaction terms, conditions and financing techniques in the current market.

Deal terms have been subject to close scrutiny since the onset of the financial crisis, due largely to their pivotal role in high profile deals. The lapsed buyouts of Huntsman Corporation and BCE Inc., both of which lapsed largely because of material adverse change (MAC) clauses and solvency issues, are just two examples of transactions that have impacted public awareness of specific private equity deal terms.

Not surprisingly, most respondents have paid particularly close attention to MAC clauses in the past year: 71% of respondents have incorporated MAC clauses into buyer closing conditions during this time, making this the most widely used closing condition among respondents this year. In the year ahead, respondents expect to see an increase in the usage of MAC clauses specifically as well as an increase in the usage of buyer closing conditions in general.

The private equity industry has indeed been adjusting to the dried up credit markets, but the industry has not necessarily become less aggressive. In fact, 61% of respondents say their targeted returns have remained unchanged for the past several years. Respondents’ use of seller financing to fund deals has also remained steady: 58% of respondents report that over the past year, seller financing or earn-outs accounted for up to one quarter of the total purchase price, and 53% of respondents say seller financing or earn-outs account for the same portion of the purchase price on current investments as compared to 2007 or earlier.

While most respondents use the same amount of seller financing as they did two years ago, their reasons for using seller financing today seem to have adjusted to current market conditions. 54% of respondents say they use earn-outs primarily to address the gap between buyer and seller expectations, a gap which 81% of respondents do not expect to narrow until next year. More traditional uses for seller financing, such as incentivizing or motivating management, are expected to be less prominent.

Respondents’ approach to their portfolio investments also speaks to current market conditions: more than half of respondents who are delaying planned exits intend to do so for at least one year, due largely to the unfavorable valuation climate for sellers. During this time, 42% of respondents say improving operational performance will be their primary objective.

In terms of industry-specific predictions, the large majority of respondents will not change their sector focus in the upcoming year. But of the respondents who do plan to change their sector focus, the Consumer and Technology industries are each cited by 67% of respondents as the industries they expect to gravitate towards in the coming months.

Overall, the outlook for the upcoming year is optimistic. 81% of respondents expect valuation gaps between buyers and sellers to narrow in 2010, with 45% estimating in the first half of the year and 37% estimating in the second half.

This survey provides an in-depth look at how the private equity industry is applying specific terms and conditions to current transactional activity, working around unprecedented financing difficulties and managing their current investments. We hope you find this survey both useful and informative, and as always, we welcome your feedback.

In the third quarter of 2009, mergermarket interviewed 75 senior level private equity practitioners in North America to gauge their sentiment on current portfolio management strategies and expectations for negotiating deal terms in the current market. Respondents provided invaluable insight into trends in the usage of specific deal terms, as well as a detailed outlook for the upcoming year. All respondents are anonymous and results are presented in aggregate.




What are your top three preferred method(s) or structure(s) for investing in this environment? What were your top three preferred methods prior to the credit crisis?

On average, what are your targeted returns for new investments?

Despite the limited availability of debt financing, respondents’ preferred investment methods have generally remained unchanged in recent years. LBOs have remained the preferred method of investing for the large majority of respondents. In fact, the percentage of respondents who cite LBOs as their preferred investment structure has remained almost exactly the same since the onset of the financial crisis, decreasing from 85% to 82%. Additionally, minority equity investments in private companies and bank debt purchases aimed at gaining control of a company remain the second and third most popular investment methods, each cited by about one third of respondents. Both of these methods were only slightly less popular before the crisis.

Many respondents acknowledge a less favorable financing climate for LBOs, but they consistently emphasize that financing difficulties have not necessarily made LBOs less attractive. Indeed, respondents point out that their firms are now using alternative approaches but plan to become more heavily involved in LBOs when the debt markets improve.

Many commentators expected the turmoil in the credit markets to drive private equity sponsors from LBO structures to alternative structures that were not as reliant on debt financing. Instead, the principal impacts have been on deal size and valuations. The current credit markets are more accommodating to middle market and smaller transaction sizes and lower valuations support expected target returns.

Akin Gump Strauss Hauer & Feld LLP

59% of respondents target returns of 25% or higher for new investments, while approximately one quarter target slightly more modest returns in the 20% to 24% range. One executive explains that poor economic conditions should not diminish investors’ expectations, especially since investments made today will likely be long term, with exits planned for when market conditions improve.

Analysis

0

10

20

30

40

50

60

70

80

90

LBOs

Per

cent

age

of r

espo

nden

ts

Purchas

e of ban

k debt to gain

contro

l of

Compan

y thro

ugh debt-to-e

quity co

nvers

ion

Minority e

quity posit

ion in a

privat

e com

pany

Section 36

3 or o

ther d

istre

ssed as

set s

ales

Purchas

e of ban

k debt as d

ebt inve

stment

Mezzan

ine debt with

war

rants

Provid

e selle

r finan

cing (r

olling equity

in a cu

rrent p

ortfolio

com

pany)

PIPEs

Preferred strategy prior to credit crisis

Current preferred strategy

85%82%

29%33%

29%31%

22%25%

17%21%

17%19% 18%17%18%22%

4%

59%

11%

26%

10-14%

15-19%

20-24%

25%+



05



How does this percentage compare to your targeted returns in previous years (2007 or earlier)?

What percentage of your time is spent on add-on acquisitions for existing platforms, or otherwise working with existing platforms to grow or stabilize current offerings?

We see our clients spending much more time on existing portfolio companies. Much of the focus has been on delevering the balance sheet, maintaining margins in the face of flat or declining revenues, implementing cash conservation strategies and modifying management incentive programs to reflect changed business conditions.


Adverse market conditions have generally not caused respondents to be any less aggressive when it comes to targeted returns. 61% of respondents say their targeted returns have not changed in recent years, while roughly one quarter of respondents target higher returns compared to the years leading up the financial crisis, most likely driven by a heightened level of risk.

One respondent who says his firm has been targeting higher returns than usual over the past year says steeply discounted distressed assets have allowed for higher expectations, as many of these targets are undervalued but fundamentally strong companies.

Respondents do not devote a significant portion of their time to add-on acquisitions, or growing or stabilizing offerings for their current existing platforms. The largest percentage of respondents (45%) devote less than a quarter of their time to these initiatives, followed by nearly one third who spend between one quarter to one half of their time in these areas. Still, it is worth noting that a quarter of respondents overall spend between half to all of their time focusing on add-on acquisitions, or growing or stabilizing current investments.

Several respondents comment that working with existing investments is a priority at the moment, as exits are not necessarily a viable option and add-on acquisitions tend to require financing that is hard to come by in the current market.

24%

61%

15%

Equal to previous targets

Higher

Lower

7%

18%

45%

30%

Less than 24%

25% to 49%

50% to 74%

75% to 100%




The survey’s results are representative of the general weakness in the global economy with operating performance at debt-laden portfolio companies deteriorating over the last twelve months, leading to severe liquidity issues and, in many cases, covenant defaults. Unable to refinance in these tight credit markets, financial sponsors are seeking creative restructuring solutions to maintain their optionality and extend their equity runway. Common solutions being discussed range from credit agreement amendments to exchange offers, discounted debt buybacks, and pre-packaged bankruptcies. With over $125 billion of loans maturing each quarter in 2010, these trends could continue for quite some time.

BMO Capital Markets

The robust LBO market in 2003-2007 has left many companies saddled with historically high debt loads in an environment of flat or declining revenues. On top of this are looming maturity dates on LBO debt coming due in 2011-2014. The combination of these factors is expected to result in continued pressure to restructure existing debt through this period. In addition, the return of robust equity markets is likely to spawn a new round of IPO financings for well positioned companies.


What is the likelihood you will have to restructure an existing portfolio investment?

When making investments in the next 12 months, what percentage of the purchase price do you expect to fund with third-party debt?

The large majority of respondents (69%) believe they will likely have to restructure an existing portfolio investment in the year ahead, and an additional 16% have already done so or are in the process of doing so. Respondents stress that restructuring activity has been on the rise in recent months, and one respondent expects this trend to continue for at least two years.

Over the next 12 months, the largest percentage of respondents (46%) expects third-party debt to account for about one quarter to one half of the purchase price on new investments, followed by nearly a quarter who say third-party debt will account for one half to three quarters of the purchase price. A comparable 21% say one quarter or less of the purchase price will be funded by debt.

Surprisingly, financing difficulties seem to have a minimal impact on respondents’ outlook for third-party debt funding in the year ahead. But one respondent explains that while his firm expects to rely somewhat heavily on debt financing for upcoming deals, his firm has also adjusted its strategy in recent months to focus on smaller deals in the lower mid-market range.

16%1%

14%

22%

47%

Very likely

Somewhat likely

Not likely

Will definitely not occur

Already restructured or in theprocess of restructuring anexisting portfolio investment

24%

21%5%4%

46%

1%-25%

26%-50%

51%-75%

>75%

No debt will be used in theupcoming year



07



For investments made in the previous 12 months, what percentage of the purchase price was funded with third-party debt?

When making investments in the previous 12 months, what percentage of the purchase price was comprised of earn-outs or seller financing?

In the past year, 32% of respondents funded one quarter to one half of the purchase price of their investments with third-party debt. 46% of respondents expect to fund the same portion of the purchase price with third-party debt in the year upcoming.

Again, although the proportion of third-party debt funding has remained relatively steady, deal values have decreased for many respondents who cite firms’ movement away from the large-cap range and into the mid-market range, where financing difficulties are less likely to hinder deal flow.

Most respondents (58%) say investments made over the past year typically incorporated seller financing or earn-outs worth up to one quarter of the total purchase price, while an additional 19% of respondents say seller financing or earn-outs represented between roughly one quarter to one half of the purchase price. 22% of respondents did not use seller financing over this time.

26%

27%

14%1%

32%

1%-25%

26%-50%

51%-75%

>75%

No debt was usedover this time

58%

22%

1%

19%

1%-25%

26%-50%

51%-75%

No earn-outs or seller financingwere included over this time

While earn-outs can prove to be an effective bridge between price expectations of buyers and sellers, they do bring the risk of post-closing disputes, particularly if they are poorly structured. This can be quite problematic for sponsors if the beneficiaries of the earn-out include the management team running the day-to-day business. The successful earn-out is predicated on a clear business understanding between the parties, particularly in the event of contingencies such as acquisitions and dispositions; changes in the business necessitated by economic conditions and changes in the management team.





How does this percentage compare to previous years (2007 or earlier)?

53% of respondents say seller financing or earn-outs account for the same portion of the purchase price on current investments as compared to 2007 or earlier. But aside from this majority, respondents are largely divided: approximately one third say this percentage has increased since 2007 or earlier, but 17% say the percentage has decreased over this time.

More respondents say seller financing and earn-out values have increased rather than decreased, and this could be attributed in part to investors’ concerns over keeping healthy companies on track. In a climate where distressed companies seem to outnumber healthy ones, one respondent stresses the importance of keeping companies focused on continued growth by using earn-outs to “motivate” management teams.

Working capital and earnings are the two most prominent bases for post-closing price adjustments, according to 56% and 49% of respondents, respectively. Cash flow is cited by a third of respondents as the most common determining factor for post-closing price adjustments.

When you have used post-closing price adjustments for existing investments, what are they typically based on?

0

10

20

30

40

50

60

Per

cent

age

of r

espo

nden

ts

56%

49%

33%

15%

11%

Assets

Debt

Working ca

pital

Earnings

Cash flo

w

24%

17%

53%6%

Lower

Higher

Significantly higher

No change

Seller financing is potentially a cheaper financing source for buyers when compared to the costs of second lien or mezzanine financing sometimes used in leveraged transactions. Interest rates are typically lower and often accrue without cash payment until final maturity. Plus there is no commitment or underwriting fee associated with seller financing.


The prevalence of working capital adjustments reflects the fact that working capital (usually) takes into account the other categories listed above, at least on a ‘current’ basis.




09



Which of the following do you expect to be the primary purpose for earn-outs in the next 12 months?

What do you typically base earn-outs on?

The majority of respondents (54%) expects to use earn-outs primarily to bridge the gap between buyer and seller expectations. Indeed, many respondents point out that economic uncertainty has created an unfavorable valuation climate for many sellers as they are often dissatisfied with buyers’ low valuations. Fewer respondents (40%) will use earn-outs to incentivize management, which one respondent says is what earn-outs have traditionally been used for in his experience. Interestingly, very few respondents expect financing concerns to affect their usage of earn-outs: only 6% expect earn-outs to be used to reduce the initial equity or cash portion of a purchase price.

An overwhelming 90% of respondents say they typically base earn-outs on EBITDA, followed by less than a quarter each who base earn-outs on sales targets and revenue targets. Profitability of certain product or service offerings and R&D benchmarks are least likely to be used as a basis for earn-out values for respondents, however, an executive draws attention to the fact that these particular benchmarks tend to vary in importance according to the dynamics of a given industry. Companies in the Technology and Pharmaceutical industries, for example, tend to rely more heavily on R&D and product development than other companies.

54%6%

40%

To bridge the gap betweenbuyer and seller expectations

To incentivize management

To reduce the initial equity/cash payment

0

10

20

30

40

50

60

70

80

90

100

Per

cent

age

of r

espo

nden

ts

90%

21% 19%14%

4%

Profit

abilit

y of s

pecific

products

/serv

ices

R&D benchm

arks

EBITDA

Sales t

argets

Reven

ue targ

ets

Earn-outs provide several benefits to buyers. Buyers can use earn-outs to trump competing offers in a competitive sales process, reduce a buyer’s initial cash consideration and motivate and retain management by aligning buyer and seller interests post-closing. But the risks of post-closing disputes posed by earn-outs should be carefully considered since disputes with in-place management can be disruptive to the post-closing business.Akin Gump Strauss Hauer & Feld LLP

When using EBITDA as an earn-out measure, the sellers will typically want to make additional adjustments to eliminate the impact of the deal on normalized earnings. These might include adjustments backing out management fees paid to the sponsor, accounting changes, non-cash compensation costs resulting from equity based incentive programs, financing costs (including costs arising out of future restructurings of the balance sheet) and other costs outside of the core operations of the target.Akin Gump Strauss Hauer & Feld LLP




In the next 12 months, do you plan to change your sector focus?

If so, which sector(s) do you plan to focus on?

An astounding 96% of respondents do not expect to change their sector focus this year. Several respondents representing the majority say their firm prefers to stick with its area of expertise, although distressed opportunities in other sectors are becoming increasingly attractive and causing both financial and strategic buyers to move beyond their traditional strategies.

The Consumer and Technology industries are by far the most popular sectors for respondents who plan to change their sector focus this year. Automotive, Financial Services, Healthcare, Industrials and Telecom are each identified by a third of respondents as the sector they will most likely shift to this year.

The high percentage of respondents gravitating toward the Consumer sector is due in part to the distressed opportunities this sector is expected to present. Indeed, the industry has seen a fair share of bankruptcy filings over the past year and this trend is one that many respondents say will continue for at least one year.

4%96%

Yes

No

0

10

20

30

40

50

60

70

80

Per

cent

age

of r

espo

nden

ts

67% 67%

33%33%33%33%33%

Financia

l Serv

ices

Teleco

m

Healthca

re

Industrial

s

Consum

er

Tech

nology

Autom

otive

Some analysts speculated that private equity firms might re-think their sector focus in light of the current economic turmoil – potentially targeting more counter-cyclical industries or those that do not exhibit much cyclicality at all. This survey reveals what we are seeing in the marketplace – that private equity has a commitment to its LPs to maintain its core investment strategy even through temporary changes in macroeconomic conditions.

BMO Capital Markets


11




In the next 12 months, which of the following alternative financing methods do you expect to be most common?

In the next 12 months, what do you expect to happen to the usage of buyer closing conditions?

The largest percentage of respondents (44%) expect seller paper to be the most common method of alternative financing in the upcoming year, while rollover equity and earn-outs were each chosen by over one quarter of respondents. Seller paper, for many respondents, is viewed as an increasingly attractive method of working around financing difficulties. Others believe seller paper will be used primarily to “drive up the total deal value or purchase price.”

One executive is especially keen on using rollover equity in the year ahead, as this form of seller financing is often highly effective in terms of attracting financial buyers, while another emphasizes the ongoing benefits of earn-outs as they tend to “enhance operational performance over the long term.”

Half of respondents expect to see an increase in the usage of buyer closing conditions this year, and an additional 43% expect usage of buyer closing conditions to remain at its current level. Many respondents who expect usage levels to remain the same say their firm has already increased its use of buyer closing conditions in the past year.

50%

43%

7%

Increase

Decrease

Remain the same

0

5

10

15

20

25

30

35

40

45

50

Per

cent

age

of r

espo

nden

ts

44%

29%27%

Earn-o

uts

Seller p

aper

Rollove

r equity




Which of the following buyer conditions to closing have you used in the previous 12 months?

On a scale of 1 to 5, how often do you expect to include the following buyer conditions to closing over the next 12 months? (where 1 = rarely and 5 = almost always)

MAC clauses, which over the past year have been the most heavily used closing condition by the large majority of respondents, are also expected to be used more than other buyer conditions to closing in the year ahead. Legal opinions are expected to be used moderately as well.

Again, the emphasis on MAC clauses seems to stem from high profile lapsed transactions in which MAC clauses proved influential. One respondent expects his firm to spend more time “analyzing the specific conditions” in MAC clauses, while another agrees that drafting MAC clauses in general will require more diligence than in previous years.

Nearly three quarters of respondents (71%) have incorporated MAC clauses into buyer closing conditions over the past year, making this the most widely used closing condition among respondents during this time. Many respondents acknowledge highly publicized lapsed transactions in which MAC clauses played a significant role — such as the buyout of Huntsman Corporation by private equity backed Hexion Specialty Chemicals, where MAC clauses were used to justify the buyer’s decision to abandon the deal — as a major force behind their use of MAC clauses in recent months.

Other buyer closing conditions are common as well, such as minimum revenues or EBITDA requirements, legal opinions and receipt of third party financing, which are all identified by more than half of respondents as buyer conditions to closing used in the past 12 months.

0

10

20

30

40

50

60

70

80

Per

cent

age

of r

espo

nden

ts

71%

58%54% 53%

40%

Receipt o

f third

party

finan

cing

Due diligence

out

MAC clau

ses

Minimum

reve

nues,

EBITDA, etc. Legal

opinions3.2

3.4

3.6

3.8

4.0

4.2

4.44.29

3.79

3.66 3.64 3.63

Due diligence

out

Minimum

reve

nues,

EBITDA, etc.MAC cl

ause

s

Legal opinions

Receipt o

f third

party

finan

cing

Beginning with IBP v. Tyson Foods and reaffirmed in Hexion v. Huntsman, the Delaware courts have made MAC clauses very difficult to invoke as a closing condition to a merger. This may explain why objective standards such as minimum revenues or EBITDA are second on this list.Akin Gump Strauss Hauer & Feld LLP

Conditioning the closing of a transaction on receipt of legal opinions has, in our experience, been on the decline in recent years. This data may indicate a reversal in this trend as market participants place a greater emphasis on downside risk protection.Akin Gump Strauss Hauer & Feld LLP


13




As credit markets tightened, acquisition multiples have generally declined precipitously (with the reduction of acceptable total leverage). Private equity firms are delaying portfolio company exits and instead focusing on improving internal operating performance and controls, and shoring up the balance sheet as they wait for the economy to recover. In this market, protracted sales may also offer the benefit of an expanded buyer universe if the ultimate suitor is also a private equity firm.BMO Capital Markets

On a scale of 1 to 5, how often do you expect the following issues to be included as an exception to MAC definitions when doing a deal? (where 1 = rarely and 5 = extremely often)

Respondents expect changes in the performance of a target’s industry to be the most heavily used exception to MAC definitions in deals this year. Interestingly, this exception is viewed by many respondents as a response to adverse industry conditions across the board. Some respondents expect buyers to have a difficult time walking away from deals even with heavily detailed MAC clauses. One respondent explains: “In the current climate, it is going to be very difficult for buyers to argue that one industry is in worse shape than another, or that industry conditions are volatile enough to justify pulling out.”

In the previous 12 months, have you delayed any of your planned portfolio investment exits?

While the majority of respondents (65%) have not delayed any planned exits in the past year, there are still slightly more than a third who have, many of whom point out that this is a poor time to bring companies to market as valuations are often unfavorable and do not necessarily reflect a company’s true value or potential.

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

3.363.14 3.11 3.05

2.63

Changes i

n over

all

econom

ic co

nditions

Unforese

en ev

ents

including w

ar,

terroris

m, e

tc.

Changes i

n the perfo

rman

ce

of ta

rget’s

broad

er industr

y

Changes i

n the la

w or

regulat

ory envir

onment

Expre

ss in

clusio

n of

short

term

effects

35%

65%

Yes

No

Because it is so difficult to prove that a MAC has occurred under Delaware law, buyers should negotiate bright-line objective standards - based on targets’ specific circumstances - for when a buyer can terminate a transaction. MAC clauses should be relied upon only for unforeseen events and changes.Akin Gump Strauss Hauer & Feld LLP




If yes, for how long do you expect to delay any such exits? If yes, which of the following best describes your strategy for the investments you will exit later than planned?

Of respondents who are holding onto investments for longer than expected, 42% say they are focusing on improving operational performance, and approximately a quarter of respondents are focusing on cutting costs. These two strategies are most common among respondents, however, other strategies are fairly popular as well, such as growing through add-on acquisitions and reworking a company’s capital structure.

54% of respondents who are holding onto investments for longer than they had originally planned do not expect to exit these investments for at least one year, or possibly longer. A smaller but still significant 38% plan to exit these investments in six months to one year.

Respondents tend to believe that exit strategies will be adjusted depending on company specifics. Companies going public for the first time, for example, will likely delay their debut as they wait for the valuation climate to improve.

38%

8%

54%

3-6 months

6-12 months

More than 12 months

23%

42%8%

15%

12%

Improving operationalperformance

Implementing newcost-cutting measures

Growing through add-onacquisitions

Focusing on reworking thecompany’s capital structure

Selling off non-core assets/carve-outs

Any delay in a planned exit may require refinancing of existing indebtedness. Taking advantage of any ‘windows’ in the debt markets may prove beneficial in the long run.



15




If in the next 12 months you were to take one of your portfolio companies to market, would you use a narrow process (defined as less than 20 parties) or a broad auction?

Respondents are divided when it comes to preferred auction processes for portfolio company auctions planned for the upcoming year, with about half preferring broad auctions and half preferring narrow auctions. Shedding light on this split, respondents from each side explain the benefits of both: one respondent says narrow auctions allow his firm to “focus on the target buyer universe”, while a respondent who prefers broad auctions says working with a higher number of bidders typically results in a higher purchase price.

When do you expect valuation gaps between buyer and seller expectations to narrow?

Overall, 81% of respondents expect valuation gaps to narrow in 2010, with the slight majority (44%) of these respondents forecasting the first half of that year. Only a small fraction of respondents believe expectations have already leveled out in the first half of 2009, while roughly one tenth believe this occurred in the second half 2009. Approximately one tenth of respondents are less optimistic about the valuation climate going forward, predicting that the gap between buyer and seller expectations will not narrow until 2011 or later.

49%

51%

Narrow

Broad

37%

44%

1%

8%10% H1 2009

H2 2009

H1 2010

H2 2010

2011 or later

Buyers should consider using earn-outs and rollover equity as potential solutions for bridging valuation gaps between buyers and sellers. Earn-outs and rollover equity require lower up front cash consideration from buyers and motivate sellers to continue to actively grow the target business to increase their payday from future events.Akin Gump Strauss Hauer & Feld LLP

The decision to go broad or narrow is highly dependent on the deal, and less so on the current economic conditions – more a function of the seller’s competing objectives to maintain the confidentiality of the process and to maximize the auction tension. To try and take advantage of both, in recent deals, certain private equity firms have performed ‘fireside chats’ to test the market with top tier buyers prior to launching a full-scale process. BMO Capital Markets




16

In your opinion, what impact do you think the new administration will have on transactional activity in the next 12 months?

When do you expect the financing markets to improve?

75% of respondents expect to see increased regulatory oversight over transactional activity in the year ahead. In addition to this, 42% of respondents expect the government to influence sector specific transactional activity by offering economic incentives, and approximately one quarter of respondents believes the government will directly participate in transactional activity.

Respondents are relatively optimistic about financing conditions in the years ahead. 61% of respondents expect the markets to improve in the second half of 2010, while nearly one quarter of respondents expect to see improvements in the first half of that year. Most of the remaining respondents (13%) do not expect to see improvements to the financing markets until 2011 or later and only a small fraction of respondents believe financing conditions have already improved in the second half of 2009.

0

10

20

30

40

50

60

70

80

Per

cent

age

of r

espo

nden

ts

75%

42%

26%

Direct

govern

mental

partic

ipation

Increas

ed regulat

ory

over

sight

Facilit

ating tr

ansa

ctions i

n

certa

in industr

y secto

rs

thro

ugh econom

ic ince

ntives

61%

22%

13%

4% H2 2009

H1 2010

H2 2010

2011 or later

The Obama administration’s impact on deal activity will certainly vary by industry. For example, implementation of a cap and trade system for carbon emissions is expected to increase investment attention to businesses involved in ‘green’ technology, while uncertainty about the results of healthcare services legislation could push investor capital to other sectors.Akin Gump Strauss Hauer & Feld LLP




www.mergermarket.com 17

The Purchase Price Earn-Out: Potential Fuel for Dealmaking by David J. D’Urso, Partner, Akin Gump Strauss Hauer & Feld LLP

Despite the sustained economic downturn and significant decline in private equity M&A activity, deals are still closing. Certainly dealmaking is not what it once was in more liquid periods, and transaction amounts, in addition to deal volume, are considerably smaller in size. Distressed acquisitions, special situation investments and loan-to-own transactions are currently comprising the bulk of M&A activity for private equity investors. Not surprisingly, deals are being structured overwhelmingly in favor of the purchaser, resulting in a clear shift away from the “seller’s market” of the past few years fueled by easy access to cheap capital. In fact, the majority of respondents to this poll maintained that economic uncertainty has created a valuation climate that favors the purchaser. Additionally, increased equity contribution percentages due to tight credit markets have caused purchasers to offer lower prices for targets. However, sellers categorically remain optimistic about anticipated valuations for their assets when entering the marketplace despite fears of cashing-out out at the bottom of an economic cycle.

With this dichotomy, dealmakers should look to purchase price earn-outs to help bridge the valuation gap between purchaser and seller expectations. If properly implemented, purchase price earn-outs - deferred consideration payable only upon the achievement of predetermined milestones - can act as key drivers to consummate transactions. While earn-outs add complexity, careful structuring of an earn-out can ultimately guide a deal to closing and induce more purchasers and sellers to get back into the market.

Benchmarks and Milestones

Earn-outs can bridge the gap between seller expectations and purchaser realities by allowing the purchaser to offer a higher top-line purchase price with a portion of the purchase price payable when and if the target business achieves enumerated milestones. This entices the seller to accept lower initial consideration with the expectation of additional future payments. In addition, this insulates the purchaser from potentially overpaying for assets in an economic environment where a “recovery” may or may not be in the near future. If the target business achieves the milestones during the earn-out period, the purchaser should be happy to pay the balance of the purchase price since the target business should be more valuable upon such achievement.

The successful earn-out must be structured on methodologies and criteria that align purchaser and seller expectations and motivations. At the onset of deal negotiations, it is critical that purchaser, seller and their respective advisors engage in a forthright dialogue regarding how to define earn-out milestones, payments and governance of the business during the earn-out period. Earn-outs are typically based on EBITDA, as evidenced by the 90% of survey respondents who pointed to this method when asked how they base earn-out payments. Purchasers tend to favor EBITDA targets as the most accurate depiction of the company’s financial health. Alternative methodologies for calculating benchmarks include sales and revenue targets, profitability of specific products/services and R&D benchmarks.

Sellers should not agree to an earn-out without accepting the risk that the purchase price paid on the closing date could be the sole consideration for a transaction. While the seller is given the opportunity to increase the amount of consideration payable upon their exit event by properly structuring an earn-out in their acquisition agreement, they must realize that the payment of any additional consideration is ultimately based on the future performance of the target business and not within the four corners of any legal document.

Operational Control

A key component of earn-out provisions outlines how the target business will be managed during the earn-out period. While the purchaser will have legal ownership of the target business after closing the acquisition, the seller often continues to be involved in the day to day business operations during the earn-out period for both transition purposes and to insure the seller’s potential payday from achieving the earn-out milestones. Clearly, the seller has a direct economic interest in the performance of the target business during the earn-out period and the seller should therefore negotiate for some level of authority to manage and operate the business during the earn-out period. The acquisition agreement should delineate parameters on how the business will be operated during the earn-out period either by reference to a business plan or more detailed operational covenants that address investment, personnel and integration decisions. Earn-outs work best and are most enticing to sellers when the seller takes an active role in the post-closing operation of the business.


www.mergermarket.com18

Although the purchaser should directly benefit from the achievement of the earn-out milestones based on increased valuations of the underlying business, the purchaser needs to balance potentially short-sighted seller motivations to hit the earn-out benchmarks against the longer term health of the target business. A careless purchaser runs the risk of granting too much control to the seller who may make business decisions based on the potential for maximizing earn-out payments. The Purchaser should be aware that Delaware courts have concluded that implied covenants of good faith and fair dealing require purchasers to give the seller a fair opportunity to operate a target business in a manner to maximize earn-out consideration. Therefore, checks and balances are appropriate and earn-outs work best when they apply to shorter periods – 12 to 24 months – at which point, the purchaser will need unregulated control of the business to execute on its strategic objectives.

Since courts often have difficulty determining appropriate damages in litigation involving earn-outs, the seller should require earn-out provisions to specifically address the issue of damages in the event disputes arise under the business governance mechanics. Liquidated damages - fixed damages agreed upon by the parties in advance as payable in specific circumstances - are useful where proving actual damages may be difficult if the purchaser fails to operate the business in accordance with negotiated covenants included in the acquisition agreement. For example, a seller may request that the earn-out be paid in full notwithstanding the achievement of the milestones if the seller’s employment with the target is terminated without cause or if the purchaser fails to make capex in accordance with an agreed upon budget.

Tax and Accounting Considerations

A properly structured earn-out requires the active involvement of tax and accounting advisors early in the process in order to insure that the parties’ agreed upon objectives are not undermined by tax or accounting issues. Unless the seller elects to opt out of the “installment method”, the seller would generally get the benefit of tax deferral and recognize the deferred portion of the consideration only when, and if, actually paid. Additionally, earn-outs can be treated as purchase price thereby resulting in a general treatment as capital gains to the seller and increased basis for the purchaser. In certain circumstances, earn-outs could be treated as compensation for employment services resulting in the opposite effect – ordinary income to the seller and an expense deduction for the purchaser. One of the key factors in determining whether an

earn-out is treated as purchase price or compensation is whether the earn-out is automatically triggered or forfeited upon the termination of the seller’s employment with the business.

Additionally, purchasers should be mindful of recent FASB pronouncements implemented at the end of 2008 regarding accounting for earn-outs payable in cash. The new rules require that future earn-out payments must be assigned a fair value at the closing of the transaction and subsequently recalculated at each reporting date. Fluctuations in the changing value of the earn-out can be problematic for purchasers who want to avoid earnings swings. Purchasers also need to consider the quarterly recalculation effect on their loan agreements and the impact that earn-out obligations may have on compliance with any financial covenants included in such agreements.

Bridging the Valuation Gap

In the uncertain economic environment which seems to have conflicting reports about varied alphabetical shaped economic recoveries at every flip of the financial papers, both purchasers and sellers are approaching dealmaking cautiously. Purchasers are concerned about overpaying for targets and sellers are faced with diminished negotiating power, particularly when a seller may be frantically eying exit strategies for a distressed company. In this market, earn-outs can entice sellers to consummate transactions in situations where the initial offered consideration does not equal their expectations. The potential for additional consideration upon the achievement of predetermined milestones improves the attractiveness of offers and both the purchaser and seller benefit if the benchmarks are subsequently achieved.

While including earn-outs as a component of the purchase price can add complexity to the dealmaking, earn-outs have the potential to increase current deal activity by enticing purchasers and sellers to bridge valuation gaps. Understanding the initial structural considerations and pitfalls of earn-outs can facilitate negotiations and improve expectations and realizations for both purchasers and sellers in the dealmaking process.

Looking for cutting-edge legal advice and management services to best position you to achieve your deal objectives? Recognized by Chambers USA 2009, Chambers Global 2009 and the Practical Law Company’s Which Lawyer? Yearbook, Akin Gump Strauss Hauer & Feld LLP’s network of more than 200 transactional lawyers represents private capital investors, mid- and large-cap companies and special board committees in connection with mergers, acquisitions and divestitures, capital markets offerings, restructurings and recapitalizations and debt financings.

Our goal is your success. With a business-oriented approach to your issues, we provide you with value-added, practical advice. As a member of your team, Akin Gump offers creative solutions to the challenges of an ever-changing business and legal landscape.

Finding the right piece of the puzzle can make the difference.

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Finding the Right Piece

Kerry BerchemAkin Gump Strauss Hauer & Feld LLPOne Bryant ParkNew York, NY [email protected]

Ken MengesAkin Gump Strauss Hauer & Feld LLP1700 Paci�c AvenueSuite 4100Dallas, TX [email protected]

Frank ReddickAkin Gump Strauss Hauer & Feld LLP2029 Century Park EastSuite 2400Los Angeles, CA [email protected]

akingump.com | 13 offices worldwide | over 800 lawyers

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Looking for cutting-edge legal advice and management services to best position you to achieve your deal objectives? Recognized by Chambers USA 2009, Chambers Global 2009 and the Practical Law Company’s Which Lawyer? Yearbook, Akin Gump Strauss Hauer & Feld LLP’s network of more than 200 transactional lawyers represents private capital investors, mid- and large-cap companies and special board committees in connection with mergers, acquisitions and divestitures, capital markets offerings, restructurings and recapitalizations and debt financings.

Our goal is your success. With a business-oriented approach to your issues, we provide you with value-added, practical advice. As a member of your team, Akin Gump offers creative solutions to the challenges of an ever-changing business and legal landscape.

Finding the right piece of the puzzle can make the difference.

© 2

009

Akin

Gum

p St

raus

s H

auer

& F

eld

LLP.

Atto

rney

Adv

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Finding the Right Piece

Kerry BerchemAkin Gump Strauss Hauer & Feld LLPOne Bryant ParkNew York, NY [email protected]

Ken MengesAkin Gump Strauss Hauer & Feld LLP1700 Paci�c AvenueSuite 4100Dallas, TX [email protected]

Frank ReddickAkin Gump Strauss Hauer & Feld LLP2029 Century Park EastSuite 2400Los Angeles, CA [email protected]

akingump.com | 13 offices worldwide | over 800 lawyers

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AG_MergerMarket-AD.pdf 1 10/8/09 5:50 PM




Perspectives from an Investment Banker

As we draw towards the close of a very challenging 2009, the results of this study could not be more timely. With the Dow and S&P up almost 50% from the market’s March 9th lows, investors in both public and private equity are poised to deploy capital for fear that they will miss the next swing to the upside. While some private equity professionals surveyed believe the market run-up may be short-lived, they see plentiful opportunities to deploy capital. Certain findings won’t strike the reader as surprising yet others may. This survey was conducted in the summer of 2009 and was focused exclusively on middle-market private equity firms, with an average fund size of approximately $1.5 billion. Some of the key findings include:

Private equity investors expect less “L” in the LBO.

The well-known and well-publicized credit crunch is still working its way through the deal economy. Certain traditional mid-market financing sources are no longer in existence while other lenders’ appetite for new leveraged credit is viewed to be tepid, at best. With this backdrop, sponsors have been looking at creative investment strategies, such as acquiring distressed assets in the secondary market – either as a yield investment or as a method to ultimately develop a controlling stake in the target company following restructuring. Additionally, sponsors are increasingly active in 363 sale processes, PIPEs and mezzanine capital with equity-like characteristics.

Private equity investors have kept their hands in their pockets and focused largely on their existing portfolio companies.

A significant percentage of those surveyed indicated that they were not spending a lot of time in the past 12 months seeking new investments or add-on acquisitions for portfolio companies. Subsequent discussions reveal that many of the portfolio companies acquired in the past 2-3 years may – surprise, surprise – require some degree of restructuring. Indeed, sixteen percent (16%) have already restructured one or more of their portfolio companies and only fifteen percent (15%) believe they will most likely not require restructuring of one or more of their portfolio companies. While the outlook is highly dependent on the nature of the portfolio company in

question, many of those surveyed believe there may be another year or two left in restructuring mode. We believe this trend is unlikely to abate in the near-term but instead may actually extend another 2-3 years.

Of the deals getting done – or hoping to get done – greater emphasis will be placed on the right structure.

Related to the first point, private equity investors’ outlook for debt capital to support outright acquisitions is tepid, at best. According to the survey, roughly two-thirds (2/3) of those surveyed believe that debt will account for less than fifty percent (50%) of the funding for new deals. As private equity investors seek to deploy capital against this new credit outlook, new transactions will likely depend on a greater mix of consideration in the form of seller financing and/or performance-based earn-outs. Of the financings being completed, private equity investors appear particularly sensitive to prepayment penalties in this new credit environment and, in some instances, are willing to fully finance the purchase price and “wait out” the drought in the credit markets and re-finance when the clouds part.

The credit backdrop and broader distractions in the marketplace have delayed private equity exits.

Much more attention is being paid to fixing the challenged companies in the portfolio while trying not to impede the future value drivers for the healthy companies in the portfolio. For those companies that could pursue an exit in this environment, the lion’s share of private equity investors indicate they have delayed such plans for twelve months or more as they continue to optimize performance characteristics while also “waiting out” the broader M&A market malaise. A small percentage (15%) indicated they would delay an exit for purposes of pursuing growth via additional acquisitions. In reviewing their outlook for a recovery in the exit market, private equity investors were almost evenly split between a recovery being encountered in the first versus the second half of 2010, while a small group believed the recovery would extend beyond 2010.

Scott Humphrey, Executive Managing Director, Head of U.S. Mergers & Acquisitions, BMO Capital Markets





Despite the vast sums of committed yet uninvested private equity capital available, private equity return expectations have barely budged.

Of the investors surveyed, seventy-six percent (76%) indicated that their return expectations were equal to or higher than prior year expectations. The majority of private equity investors are still pricing mid-20 to low-30 percent returns while roughly fifteen percent (15%) indicated they would deploy capital for targeted IRRs of less than twenty percent (20%). Some might argue that as broader market return expectations in the medium-term are heading ever-lower, alternative asset classes such as private equity would follow. The survey indicates that virtually nothing has changed in pricing of private equity returns which either indicates higher levels of perceived risk in these transactions or that the asset class is seeking to post extraordinary spreads (alpha) to their traditional investment benchmarks.

Lastly, private equity investors expect that the new administration will have some impact on transaction activity in coming years.

A vast majority of those surveyed indicated that they expect increased regulatory scrutiny over future transactions while many others expect certain sectors to continue receiving some form of economic incentive to drive transaction activity.

In the past year and a half, the global financial markets have truly entered uncharted territory. As credit markets collapsed, purchase multiples were dramatically impacted. Not surprisingly, as a direct result, the appetite for planned portfolio company exits weakened – especially considering that IRR expectations for private equity firms remained largely unchanged. On the buy-side, private equity firms had to re-assess their ultimate capital structure for deals, in many cases temporarily “over-equitizing” acquisitions. This survey intends to shed some light on these and other impacts of the current market turmoil, specifically as they relate to current and future private equity investments. We hope you enjoy the findings of the survey – we certainly learned a lot in the process and look forward to future opportunities to refine the analysis and commentary. We are grateful to our colleagues at Akin Gump and mergermarket for their supportive efforts in developing, compiling and analyzing this survey.




M&A Advisory

Leveraged Finance

Sale toHicks Acquisition Co.

Financial AdvisorSeptember 2009

Sale by Gillett Family to a Consortium Led By

Geoff, Andrew and Justin Molson

Financial AdvisorPending

Merger withInternational Assets Holding Corporation


Sale to Cosmo Films Ltd.

Financial AdvisorJune 2009

Acquisition of Remaining Interest in the

Boddington Project


Acquisition ofCerticom

Financial AdvisorMarch 2009

Acquisition ofInstorage REIT


Sale toCHS, Inc.

Financial AdvisorJanuary 2009

Sale toDeVry Inc.


Acquisition ofUnipac

a Division of ITW

Financial AdvisorAugust 2008

Sale toTA Associates


Senior Secured Credit Facilitiesfor Portfolio Company of

Lead Arranger &Administrative Agent

July 2009


Chicago Growth Partners,Prairie Capital and

TwinBridge Capital Partners

July 2009 June 2009 May 2009

Co-Lead Arranger &Co-Syndication Agent


Co-Lead Arranger &Administrative Agent

Senior Unsecured Term Loan


Sale toChicago Growth Partners,

Prairie Capital andTwinBridge Capital Partners

Financial AdvisorJuly 2009

Portfolio Company ofPortfolio Company of

Division of

Subsidiary ofRosen’s Diversifi ed, Inc.

Porfolio Company of Porfolio Company of

Merger Mania.indd 3 10/15/2009 1:08:02 PM

DONEDEAL

BMO Capital Markets is a trade name used by BMO Financial Group for the wholesale banking businesses of Bank of Montreal, Harris N.A. and BMO Ireland Plc, and the institutional broker dealer businesses of BMO Nesbitt Burns Inc. (Member CIPF) in Canada, Europe and Asia, BMO Nesbitt Burns Ltée/Ltd. (Member CIPF) in Canada, BMO Capital Markets Corp., BMO Nesbitt Burns Trading Corp. and BMO Nesbitt Burns Securities Limited in the U.S., and BMO Capital Markets Limited in Europe and Australia.

® Registered trademark of Bank of Montreal in the United States, Canada and elsewhere.TM Trademark Bank of Montreal

With over 190 years of experience, we’re used to hearing the words

Getting deals done in a diffi cult economytakes both ambition and a skilled advisor.

www.bmocm.com






M&A Advisory

Leveraged Finance

Sale toHicks Acquisition Co.


Sale by Gillett Family to a Consortium Led By

Geoff, Andrew and Justin Molson


Merger withInternational Assets Holding Corporation


Sale to Cosmo Films Ltd.


Acquisition of Remaining Interest in the

Boddington Project


Acquisition ofCerticom


Acquisition ofInstorage REIT


Sale toCHS, Inc.

Financial AdvisorJanuary 2009

Sale toDeVry Inc.


Acquisition ofUnipac

a Division of ITW

Financial AdvisorAugust 2008

Sale toTA Associates




July 2009


Chicago Growth Partners,Prairie Capital and

TwinBridge Capital Partners

July 2009 June 2009 May 2009

Co-Lead Arranger &Co-Syndication Agent


Co-Lead Arranger &Administrative Agent

Senior Unsecured Term Loan


Sale toChicago Growth Partners,

Prairie Capital andTwinBridge Capital Partners

Financial AdvisorJuly 2009

Portfolio Company ofPortfolio Company of

Division of

Subsidiary ofRosen’s Diversifi ed, Inc.

Porfolio Company of Porfolio Company of





BMO Capital Markets is a leading, full-service North American fi nancial services

provider offering corporate, institutional and government clients access to a complete

range of products and services. These include equity and debt underwriting,

corporate lending and project fi nancing, merger and acquisitions advisory services,

merchant banking, securitization, treasury management, market risk management,

debt and equity research and institutional sales and trading. With over 2,400

professionals in offi ces in 27 locations around the world, including 14 in North

America, BMO Capital Markets works proactively with clients to provide innovative

and integrated fi nancial solutions.

BMO Capital Markets is a member of BMO Financial Group (NYSE, TSX: BMO),

one of the largest diversifi ed fi nancial services providers in North America with

US$385 billion total assets and 37,000 employees as at July 31, 2009.

ABOUT BMO CAPITAL MARKETS MERGERS AND ACQUISITIONS

BMO Capital Markets has a top-tier North American M&A practice, which has

extensive experience in public and private company transactions ranging from

friendly acquisitions to hostile takeovers. With the agility of a boutique fi rm and

the resources of a large fi nancial institution, BMO Capital Markets can help your

company reach its most ambitious goals. Our fi rm has longstanding relationships

across North America. With over 50 M&A professionals in the U.S. and Canada,

BMO Capital markets has proven capabilities in buy- and sell-side transactions,

restructurings, recapitalizations and strategic reviews with both the strategic and

fi nancial sponsor communities.

BMO CAPITAL MARKETS AT A GLANCE

Andre HidiExecutive Managing DirectorHead of Global Mergers & [email protected](416) 359-4744

Scott HumphreyExecutive Managing DirectorHead of U.S.Mergers & [email protected](312) 461-7672

Daniel BarclayManaging DirectorHead of Canadian Mergers & [email protected](416) 359-4754

FOR MORE INFORMATION ON OUR PRACTICE, PLEASE CONTACT:






Historical Data

US and Canadian buyouts and exits by Volume US and Canadian Buyouts and Exits by Value

The first three quarters of 2009 have generated 297 buyouts and 197 exits in the US and Canada, compared to 601 buyouts and 354 exits in the first three quarters of 2008. This represents a 51% decrease in the volume of buyouts and a 44% drop in the volume of exits.

Aggregate buyout value in the first three quarters of 2009 totals $30.3bn, representing a 57% drop from an aggregate buyout value of $70.8bn in the first three quarters of 2008. Aggregate exit value in the first three quarters of 2009 totals $12.9bn, representing a decrease of 85% from an aggregate exit value of $84.4bn in the first three quarters of 2008.

0

50

100

150

200

250

300

Q309

Q209

Q109

Q408

Q308

Q208

Q108

Q407

Q307

Q207

Q107

Q406

Q306

Q206

Q106

Q405

Q305

Q205

Q105

Q404

Q304

Q204

Q104

Buyouts

Exits

0

50,000

100,000

150,000

200,000

250,000

Q309

Q209

Q109

Q408

Q308

Q208

Q108

Q407

Q307

Q207

Q107

Q406

Q306

Q206

Q106

Q405

Q305

Q205

Q105

Q404

Q304

Q204

Q104

Buyouts

Exits




26

mergermarket is an unparalleled, independent Mergers & Acquisitions (M&A) proprietary intelligence tool. Unlike any other service of its kind, mergermarket provides a complete overview of the M&A market by offering both a forward-looking intelligence database and an historical deals database, achieving real revenues for mergermarket clients.

Any queries regarding this publication or Remark, the market research, publications and events division of mergermarket should be directed to:

Kevin Hill Publisher 646.378.3181 [email protected]

About mergermarket



027




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Disclaimer

This publication contains general information and is not intended to be comprehensive nor to provide financial, investment, legal, tax or other professional advice or services. This publication is not a substitute for such professional advice or services, and it should not be acted on or relied upon or used as a basis for any investment or other decision or action that may affect you or your business. Before taking any such decision you should consult a suitably qualified professional adviser. Whilst reasonable effort has been made to ensure the accuracy of the information contained in this publication, this cannot be guaranteed and neither Mergermarket nor any of its subsidiaries nor any affiliate thereof or other related entity shall have any liability to any person or entity which relies on the information contained in this publication, including incidental or consequential damages arising from errors or omissions. Any such reliance is solely at the user’s risk.

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Documents

FINAL REPORT - Private Equity Dynamic Conditions