Private equity sponsors struggle to make sense of the new ...

THE OFFICIAL PUBLICATION OFMAY 2010Private equitysponsorsstruggle tomake senseof the newfundraisinglandscapePLUSAssessing the Synergy PremiumLeveraged Finance RoundtableHealthcare Reform’s Impact on M&ATHEMIDDLEMARKET.COM

ContentsMay 2010 | Volume 45 | Number 05Cover StoryPinchedPrivate equity sponsorsstruggle to make sense ofthe new fundraisinglandscape24Cover Photograph by Jeffrey Coolidge / Stone / Getty ImagesThe Watercooler6 Poison pills on the wane; AmericanIdol franchise draws buyers; and excessis on the upturn; plus other news dealpros are talking aboutOutlook12 A Synergy Runup14 Smoothing the Cost Curve16 Taking the UnderLBO Watch20 Growth SpurtDebt Monitor22 Junk Debt Could Absorb LBO RevivalRoundtable36 The Re-emergence of LiquidityThe credit markets have shownmarked improvement, thoughdealmakers have different views onhow the next 12 months will unfold.Spotlight on Limited Partners29 Emerging Managers’ Catch 2232 Q&A: Coller’s Salvato on GP/LPRelationsFeatures48 Earnout Implications50 Profile: Steve Miller Back on the HuntFrom The Field54 Nowhere Left to Kick the Can56 FASB’s Fair Value Update58 PeopleAssociation for CorporateGrowth4 Who’s Who5 Letter to Members62 The Pulse64 Community Commentary

Inside WordMay 2010 Volume 45, Number 05In the latest issue of Mergers & Acquisitions, we took a long look at the fundraisingenvironment, exploring LP/GP relations, the overall market for private equitygroups and the new landscape for emerging managers.Over the past 18 months, talk of a shakeout has gripped the asset class. Nowthat funds are returning to the market after an almost two-year absence, this iswhen we’ll actually see whether or not that will happen, and if so, what it will looklike.From what I can tell by poring over SEC filings and talking to folks in themarket, I would guess there will be a lot of funds that won’t hit their ‘08 expectations.Then there will be the groups that can’t raise capital, but the principals willprobably emerge elsewhere and remain active investors, whether it’s for a family office,as part of a smaller vehicle or through a pledge fund.It’s a shakeout, sure, but I feel like compression is a better description of whatwill actually take place. The good news is that it seems to coincide with a generalview from institutional investors that the middle market represents the best opportunityfor returns. LPs should have plenty of funds to choose from.Also in this issue, Jonathan Marino delved into the pursuit of raw materialcompanies by strategic buyers looking to reduce the volatility of their costs. It’s aninteresting trend, one that will likely only become more common as long as commodityprices remain so elastic.Also, we explored synergy and its tendency to fluctuate during good and badtimes. As the economy rebounds, it’s usually the case that synergy forecasts tendto grow, although at this stage, it seems like buyers are still playing it safe.As always, thanks for reading. If you have any thoughts or comments, pleasedon’t hesitate to reach out.Thanks,Ken MacFadyenEditorUntangling theFundraising Marketken.macfadyen@sourcemedia.comEditorSenior ReportersContributing EditorsContributing ReportersKen MacFadyenken.macfadyen@sourcemedia.comJonathan Marinojonathan.marino@sourcemedia.comDanielle Fugazydanielle.fugazy@sourcemedia.comCarol Clousecarol.clouse@sourcemedia.comKelly Holman, Matthew SheahanAleksandrs Rozens, Joshua HamermanRichard KellerhalsEVP & Managing Director Capital Markets Division Michael Stantonmichael.stanton@sourcemedia.comNational Account ManagerRobert Vitriolrobert.vitriol@sourcemedia.comExecutive Director of Creative ServicesSharon Pollacksharon.pollack@sourcemedia.comArt DirectorNikhil Malinikhil.mali@sourcemedia.comAssociate Art DirectorFritz Laurorefritz.laurore@sourcemedia.comExecutive Director of ManufacturingStacy Ferrarastacy.ferrara@sourcemedia.comProduction ManagerEugene “Bud” Mocciaeugene.moccia@sourcemedia.comAdvertising CoordinatorJoshua Goolsbyjoshua.goolsby@sourcemedia.comReprint SalesFulfillment ManagerDistribution ManagerSenior Marketing ManagerSourceMedia, Inc.Chief Executive OfficerDenise Petratosdenise.petratos@sourcemedia.comJames McEvoyjames.m.mcevoy@sourcemedia.comMichael Candemeresmichael.candemeres@sourcemedia.comElizabeth Dyaselizabeth.dyas@sourcemedia.comDouglas J. ManoniChief Financial OfficerRichard AntoneckExecutive Vice President, Chief Content Officer David LongobardiExecutive Vice President, Marketing/Strategic Planning Anne O’BrienSenior Vice President, Inside Sales & Technology Adam ReinebachSenior Vice President, Director of Operations & Technology Celie BaussanVice President, FinanceRebecca KnoopSenior Director, Human ResourcesYing WongReproduction or electronic forwarding of this product is a violationof federal copyright law! Site licenses are available - please call CustomerService (800) 221-1809 or custserv@sourcemedia.comMergers & Acquisitions (ISSN 0026-0010) Vol. 45 No. 5, is publishedmonthly by SourceMedia, Inc. One State Street Plaza, 27th Floor, New York,NY 10004. Telephone: (212) 803-8200.Customer Service: For subscriptions, renewals, address changes, ordelivery service issues contact our Customer Service Department at (800)221-1809 or (212) 803-8333; e-mail at custserv@sourcemedia.com;or send correspondence to Customer Service-Mergers & Acquisitions,SourceMedia, One State Street Plaza, 27th Floor, New York NY 10004.Periodicals postage paid at New York, NY, and additional mailing offices.Subscriptions: Yearly subscription is $695; add $175 for foreign airmail.Please address subscription questions to Customer Service.Postmaster: Send address changes to: Mergers & Acquisitions/ Source-Media, Inc., One State Street Plaza, 27th Floor, New York, NY 10004.Advertising: For information, contact Robert Vitriol at (212) 803-8774or robert.vitriol@sourcemedia.com.Reprints/Web Rights: To order reprints or request web rights,contact Denise Petratos at (212) 803-6557 or denise.petratos@sourcemedia.com.This publication is designed to provide accurate and authoritative informationregarding the subject matter covered. 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LETTER TO MEMBERSACG Membership:Value in Good Times and BadThe community begins with a network of 54 chapters throughout North America,Europe and AsiaGary A. LaBranche and Dennis J. WhiteThe recession has certainly tested the fortitudeof middle-market M&A dealmakersand business leaders. While our industryhas over the years periodicallyexperienced transition and turnover, this time, thechange was more profound and affected a widerrange of individuals at all career levels. Whathas not changed during this time is the valueACG members place on their membership.During one of the most disruptive economicperiods in history, overall ACG membership“This powerful communityis no accident.”dipped only slightly between2008 - 2009 and todaywe are on track to seta new membership high in2010. In addition, two new chapters (ACG Kentuckyand ACG China) were launched and theoverall number of chapter and regional eventssurpassed 1,000. From local chapter meetings tothe China International Private Equity Forum(CIPEF) June 10 -11, 2010 in Tianjin, China, ACGprovides members local connections with globalreach. ACG members count on the connectionsand relationships available only throughACG to aid dealflow and power growth. In goodtimes and bad, the ACG community connectsmembers with opportunity and provides value.This powerful community is no accident. Itbegins with a robust network of 54 chaptersthroughout North America, Europe and Asia.Chapter events provide the opportunity for membersto create powerful face-to-face connections.In fact, more than 75 percent of ACG membersreport that they do business with fellowmembers. The community is further enhancedwith a wide array of tools and services designedto help ACG members succeed.The single most accessed tool is ACG.org.This extensive digital platform allows membersto connect with one another virtually, within achapter or across the globe, through the OnlineMembership Directory. In addition, membersmay join or create interest groups, discuss industrytrends, and receive the latest dealmakingnews and research withoutever leaving their desks.Particularly exciting isa new strategic alliance betweenACG and PitchBook Data. Part of this allianceis the enhancement of ACG CapitalLinkSM.As part of their designation as ACG’sPreferred Private Equity Research Provider, Pitch-Book is now powering ACG CapitalLinkSM withPitchBook LITE. Through ACG CapitalLinkSM,ACG members have free access to real time datafor more than 4,000 investors, 83,500 privateequity professionals, 16,000 private equitybacked companies and 1,750 service providers.In addition, ACG members receive special, exclusivepricing on the full PitchBook Private EquityPlatform, a web-based resource providing unparalleledPE information and analysis. Pitch-Book also provides members with complimentaryreports and research.In addition to providing unequalled networkingand functional online tools, ACG is committedto helping members attain their personaland professional aspirations. To that end, ACGrecently launched ACG JobSource. This onlinejob board is the first to exclusively focus on themiddle-market dealmaking community. Job seekersmay create a profile and post a resume freeof charge and ACG members receive exclusivemember only discounted pricing on job postings.With many signs pointing toward a recoveryin middle-market dealmaking, ACG will not reston recent accomplishments. As dealflow increases,ACG will continue to serve as the criticalbusiness resource members have come to expect,while exploring new ways to deliver additionalvalue. For more than 55 years, ACG hasbrought members and opportunity together andACG is well positioned for the next 50. To learnmore about all of the benefits of ACG membership,visit www.acg.org.Gary A. LaBranchePresident & CEODennis J. WhiteChairmanMay 2010 ACG > MERGERS & ACQUISITIONS 5

WatercoolerPoison Pills on the WanePublic companies in the US are less inclinedto set up hostile defense mechanisms beforesuch actions are requiredCorporate executives are apparently morelikely to avoid preventative care, at leastwhen it comes to the adoption of poisonpills and other takeover defense initiatives. Reuters,citing data from FactSet SharkRepellent, reportedthat the number of domestic companies with shareholderrights plans sat at 1,000 as of late March, atrough that hadn’t been reached since 1990.The decline, however, doesn’t necessarily reflecta shortage of hostile deals or a concession on thepart of targets that they can’t stave off unsolicited bids. Rather,as the article identified, the lower number reflects that companiesthat aren’t in play don’t want to attract negative attention fromtheir institutional shareholders. Moreover, it is generally understoodthat companies can quickly institute a shareholders’ rightsplan on an as-needed basis.To wit, in March, after Carl Icahn set his sights on LionsgateEntertainment and accumulated a 19% stake in the company,the Lionsgate board adopted a poison pill that would betriggered once a hostile acquirer’s stake exceeds 20percent. Icahn had initially sought a 30% stake inan effort to scuttle a Lionsgate bid for rival MGM.He later made a tender offer for the entire company,though analysts covering Lionsgate’s stock saw littlechance of Icahn getting his own slate of directorsin to repeal the pill.Reuters, again citing FactSet, also reported thatthe number of companies in the S&P 500 with staggeredboards had fallen significantly over the pastdecade. Last year, 164 companies had staggeredboards.Hostile activity, meanwhile, seemed to rebound in recentmonths, as Kraft agreed to acquire Cadbury, while OSI Pharmaceuticalsand Airgas each faced unsolicited bids in March andFebruary, respectively.A Media Deal Bellwether?Is it okay to again celebrate the excesses ofthe deal life?For M&A executives looking for signs of a recovery, onerecent deal may signal that the good times are not too faroff. DealFlow Media’s acquisition of Doubledown Media,the publisher of the shuttered Dealmaker, Trader Monthly andCorporate Leader magazines, could revive the titles, which in alot of ways came to symbolize the excesses of the credit bubble.After filing Chapter 7 bankruptcy last year, Doubledown wasunable to fetch any significant bids for the assets. According toFolio, the Dealmaker title received a bid of $100,000, which fellPOLITE CONVERSATION“I think people should recognize that intelligence ishelpful, but if you’re too smart, you might outwit yourself.I don’t think geniuses necessarily do as well in businessas people who are reasonably intelligent.”— The Carlyle Group co-founder David Rubenstein, as quotedby Fortune Magazineshort of the $300,000 minimum identifiedin the auction notice.Dealmaker and Trader Monthly, in additionto other titles from Doubledown,such as Cigar Report and Private Air, glorifiedthe lifestyle of deal pros and traders,featuring sections highlighting expensivecars, watches and other luxuries. The last issue,which was published after Lehman collapsedon September 15, 2008, was ananachronism to a market that had seemed long gone by the timeissue arrived in mailboxes. Doubledown was also the publisherbehind Lenny Dykstra’s Players magazine, a failed effort to targetthe ultra-high-net worth professional athleteaudience. Players was not included inthe acquisition.DealFlow Media, meanwhile, has mademoves on the M&A front before, acquiringdata analytics company PrivateRaise in 2008.Terms of the Doubledown deal were notdisclosed.6 MERGERS & ACQUISITIONS May 2010

Small TalkSo, how was your potato yield this year?Wall Street’s rogues apparently aren’t nearly as slick they thinkthey are. The Securities and Exchange Commission, in March,nabbed another insider trading ring using insider informationabout M&A to trade ahead of the deals. The guilty parties tried to hidetheir activity by using ill-conceived code words to discuss the specifics ofthe trades over email.UBS Securities’ Igor Poteroba tipped off friends Aleksey Koval andAlexander Vorobiev ahead of at least 11 transactions, according to theSEC. In various exchanges documented byregulators, Poteroba at different times used“frequent flier miles,” “coupons” for a weddingregistry, and potato harvests as code forthe trades.In one exchange, Koval describes a frequentflyer program he signed up for. “I gotfive thousand of sign-in bonus miles, butthinking maybe if I fly often, I will get additionalthree to five K miles.”Poteroba then responded that Koval “should sign up for anotherflight, if you can, since they are providing bonus mileage soon.”Next time, they might be better served discussing sports, the weather,or something people actually talk about.THEMIDDLEMARKET.COMMay’s web exclusives, found only atTheMiddleMarket.com. You can also followMergers & Acquisitions on Twitter athttp://twitter.com/TheMiddleMarket.Chemicals in DemandPrivate equity has targeted the chemicals space, butmuch of the event-driven activity over the past few yearshas started to wane, making it tough for platforms to buildthrough add-on strategies.Destination SydneyDrawn by a growinggross domestic product, theinvestment banks, led byGreenhill & Co., Lazard andMoelis & Co., are rushing toAustralia.The Leveraged LoanMarket Comes to LifeAfter three dead quarters,the primary loan marketheld a steady heartbeatthrough the first quarter of2010. Marketwatchers anticipate an even stronger quarterto follow.Flipping Through the ArchivesIn early 2009, few knew what was going to become of private equity.Mergers & Acquisitions, that March, took a close look at how the industrywould re-invent itself. The consensus among deal pros was thatsurvival would require a significant makeover and that it wouldn’t comewithout significant casualties.With the economy on the mend, this past March, the Private EquityCouncil unveiled a new study, declaring victory for the asset class byshowing that PE-backed companies managed the difficult environment betterthan other highly leveraged companies.The PEC cited that the defaultrate for private equity-backed companies was 2.84% during 2008 and 2009versus a 6.2% annualized default rate for “similarly financed businesses.”The PEC took aim at a few competing studies, saying that the resultsflew in the face of other research from the past two years, citingspecifically research from Moody’s, Standard & Poor’s and the Boston ConsultingGroup, all of which predicted more pain for the industry.The Private Equity Council is an advocacy group that was formed in2006 with backing from the largest buyoutgroups, such as Kohlberg Kravis Roberts, ProvidenceEquity Partners,The Blackstone Groupand others.While the study is among the first sincethe recession technically ended, the loomingrefinancing cliff, in which $770 billion inleveraged loans will mature by 2015, meansthat PE-backed companies are far from outof the woods. According to Thomson Reuters, roughly aquarter of the leveraged loan volume for 2010 was related to “amendand-extend”facilities, as of mid March, implying that many groups maysimply be putting off the pain.Moody’s, meanwhile, issued its own research in March, showing thatof the 163 non—financial corporate defaults last year, 77 came fromPE-backed companies.May 2010 MERGERS & ACQUISITIONS 7

WatercoolerTOMORROW’S DEALSAmerican Idol Biz Back on theBlockCKX Inc. has confirmed it is engaged in“sale discussions”CKX Inc., which has flirted with possible sales over the pastthree years, is back on the block, according to a statementfrom the company disclosing it is engaged in “sale discussions”with an unnamed buyer.The company is best known for its “American Idol” televisionfranchise, but also owns the rights to the Elvis Presley nameand likeness, and controls similar rights related to boxing greatMuhammad Ali.Robert F.X. Sillerman and Simon Fuller, chairman and CEOof CKX and a director at the company, respectively, previouslytried to acquire the business through a separate entity, 19X, Inc.In June of 2007, 19X reached an agreement to takeover CKX,although the deal was subsequentlyamended multipletimes before it was finallyterminated inNovember, 2008. The deal,which had valued the targetat $12 a share, resultedin a $37.5 million termination fee for CKX.Since then, CKX has seen its stock fall, while its performancehas improved. In 2009, CKX posted $328 million in sales,with Ebitda of $64 million, up from $288 million of sales and$60 million of Ebitda a year earlier.Multiple press reports have indicated that JPMorgan’s inhousePE arm One Equity Partners is the ‘unnamed buyer.’ TheWall Street Journal, meanwhile, in a story suggested that Sillermanwould likely maintain a significant stake.A call to CKX was not immediately returned by presstime.Give and GoThe NBA’s Golden State Warriors franchisegoes on the blockFormer Sonic Communications founder and current GoldenState Warriors owner Christopher Cohan has tapped GalatiotoSports Partners to pursue a sale of the NBA franchise.A Bloomberg report suggested billionaire and former Oraclefounder and chief executive Larry Ellison is among those interestedin buying the franchise. Street & Smith’s Sports Business Dailyreported that a sale price could top $400 million.The team did not respond to a call seeking comment. Ellison,meanwhile, was quoted by Bloomberg indicating that since 2004 thathe has considered acquiring the franchise.In recent years, a number of sports teams have changed hands.Last year, the NHL’s Montreal Canadians was sold to the Molsonfamily for a reported $550 million, while Tom Hicks was forced tosell Major League Baseball’s Texas Rangers to an investor group thatincluded Nolan Ryan. In the NBA, meanwhile, Michael Jordan recentlyassumed a majority stake of the Charlotte Bobcats fromRobert Johnson. Jordan, who paid a reported $275 million, wasable to acquire the team at a discount to the $300 million Johnsonpaid six years earlier.Gateway Energy Brings inAdvisorGrowth Capital Partners will helpoversee exploration of alternativesGateway Energy Corp., days after assembling aspecial committee, tapped Growth CapitalPartners to serve as advisor as it explores strategicalternatives. In a proxy statement, Gateway acknowledgedthat the company is “too small to be public,”but the latest effort for a sale comes amid growingagitation from activist investors.Gateway Energy Corp. owns and operates naturalgas gathering, transportation and distribution systems.The company was put in play by Frederick Pevow,Jr., a shareholder in the company since August of lastyear, who as of press time held an 11.8% stake in Gateway’sshares and was the beneficial owner of a 28%stake. In February, Pevow met with a Gateway boardmemberto discuss the possibility of an acquisition, involvingeither the entire company or its Waxahachiepipeline assets. Four days later, Gateway enacted a poisonpill, citing Pevow’s interest in the assets.8 MERGERS & ACQUISITIONS May 2010

WatercoolerBELTWAY MONITORHealthcare Reform’s ImpactDealmakers aren’t necessarily sure that thenew legislation will benefit the M&A communityClarity is supposed to spark deal activity. Yet when PresidentBarack Obama’s $940 billion Healthcare Reform Bill waspassed into law in March, deal pros seemed even more uncertainabout the impact the bill would have on M&A activity.In an unscientific poll on Mergers & Acquisitions’ website,TheMiddleMarket.com, 54% of the respondents actually consideredthe bill “bad for dealmaking,” against 36%, which consideredthe legislation “good for M&A.” The balance thought itwould have no impact.The consensus among marketwatchers is that the legislationcould hurt the insurance companies (now on the hook for pre-existingconditions) and medical device manufacturers (the victimof an excise tax), while pharmaceutical companies, hospitals andprimary care providers should all benefit as the population of insuredconsumers swells.For the broader economy, reform appears mixed. Large corporationssuch as AT&T, Verizon, Caterpillar and others projectedhigher costs as a result of the legislation. AT&T, for instance,indicated that it anticipates seeing its healthcare costs climb by$1 billion. The phone giant pointed to a tax benefit it had beenreceiving that allowed it to help pay for retiree healthcare costs,which, as part of the new plan, is not deductible.Other components of the bill that will more directly impactM&A continue to emerge. Tighter guidelines, for instance, will beput in place, to make it easier to identify nursing home ownership.Tax benefits were also extended to small companies, with under 25employees, which one might thinkcould squelch motivation to add numbers.Still, even as the details continueto get ironed out, investors and acquirerswill surely identify which areasin healthcare stand to benefit, andmove quickly to gain exposure.Cerberus Capital Management, for instance, just days afterhealthcare reform was signed into law, struck an $830 million dealwith the Boston Archdiocese’s Caritas Health Care System. Thefirm will convert the non-profit owner of six hospitals into a taxableentity, renamed Steward Healthcare Systems. Hospitals, which havebeen among the most strained by the high cost of healthcare, shouldsee a change of fortune as the number of insured patients grows.Even those areas set to be pinched by the reform bill couldsee more M&A. Some deal pros, for instance, anticipate midsizedinsurers will be motivated to quickly either build scale orfind a larger company to help absorb the coming changes.CJ Bolster, a vice president at consultancy Hay Group, notesthat changes, good or bad, introduced by new laws, generally createsopportunities for buyers. “Every time there has been a legislativechange, there has been new entries into the marketplace,” hesays, adding that he anticipates home care and hospices will become“more integrated with local [hospital] systems.”Jeff McCormack, a senior analyst at Manning Napier’s lifesciences fund, believes the legislation could create holes that needto be filled by private investors. “Any industry that is losing moneyis ripe,” he says. McCormack adds that opportunity in varioussegments will be found on a region-to-region basis. —JonathanMarinoSEC Considers Full DisclosureCompanies and executives may no longer beable to hide behind a settlementAsettlement with the Securities and Exchange Commissionmay no longer be the first option for those trying tosave face. According to a story in the Washington Post inApril, the SEC is considering a new policy that will allow theagency to publish the details of its investigations into corporatemalfeasance, even when those charged choose to settle.As it currently stands, executives that settle with the SEC maypay a fine, but are typically freed from having to admit wrongdoing.The SEC’s enforcement director, Robert Khuzami, however,was quoted by the Post as saying that the agency will be reconsideringthe practice and may look to publish “a more fulsome record”of its investigations.The article, in identifying the driver of the potential change,pointed to the uproar created when the SEC allowed Bank ofAmerica to settle charges over bonuses paid to Merrill Lynch employeesahead of the government bailout.Other cases too, however, would seem to demonstrate the benefitsof transparency. Tech investor and Dallas Mavericks ownerMark Cuban sued the SEC arguing that the regulator was biasedin its effort to charge him for insider trading.10 MERGERS & ACQUISITIONS May 2010

OutlookA Synergy Runup?Synergy estimates tend to grow when markets improve,as the focus shifts from costs to revenuesBy Ken MacFadyen“There is verylittle willingnessthese days tobid based onbelief.”Placing a value on synergy can be a tricky enterprise.As the economy turns, it can become evenmore difficult to gauge, as synergy — like traditionalsecurities — can also fluctuate with the market,especially since buyers are prone to pass along the valuein the form of a premium.“Synergies will definitely grow during hotter markets,”says Michael Frankel, senior vice president ofbusiness development and M&A at LexisNexis. Henotes that revenues around new products and saleschannels are “easier to capture” during flush times. Thecatch is that in an improving environment, executivesmay be more inclined to win a deal at any cost. “That’swhen you start to see companies use synergies to justifypaying a higher multiple,” Frankel adds.Indeed, the same way debt markets can becomeoverheated and skew valuations for buyout shops, synergyexpectations can carry the same threat for strategicacquirers.Take Cedar Fair’s $1.24 billion acquisition of ParamountParks in 2006. The 10.6x TTM Ebitda valuationmay have seemed high initially, even for a bullmarket. Cedar Fair, however, identified $20 millionto $30 million in synergies that would materialize fromthe deal, creating a pro forma purchase price of 8.5xEbitda. Analysts, almost in unison, cited the 400 basispoints difference in operating margin between thebuyer and the target, which was supposed to make thesynergy projection an easy hurdle for Cedar Fair. Thispast February, however, management finally concededthat the deal was a dud. CEO Dick Kinzel, in addressingcertain impairment charges in the company’s yearendearnings call, blamed missed expectations for the“performance of certain acquired parks,” coupled withthe higher cost of capital, a factor that was only mademore acute by the purchase.During the past 18 months, however, buyers havebeen remiss to pass along any anticipated synergy valueto sellers. For one, with private equity out of the picture,few buyers have been pushed to do so. The otherfactor is that with the cost of capital so high, executivesare taking a much harder look at synergy forecasts.“There is very little willingness these days to bidbased on belief,” Boston Consulting Group’s Jeff Gell,a partner and managing director at the firm, tells Mergers& Acquisitions. “Valuations are going to be based onnumbers that buyers view as fact.”When Phillips-Van Heusen shelled out $3 billionfor Tommy Hilfiger in March, the talk seemedto center on the potential for overseas growth.Phillips-Van Heusen, though, only outlined $40 millionin synergies, which the company’s chief executiveEmanual Chirico identified in a quarterly earningscall as being solely related to cost cutting and“principally based in North America.” He added thatrevenue synergies were not embedded at all in thecompany’s guidance.To be sure, there is usually a difference to the projectionsWall Street may get and the true goals of management.Gell notes the forecasts that find their way intoforward looking guidance are the numbers managementis staking their credibility on. “Not hitting thatforecast is a huge red flag,” Gell identifies, citing thatactual internal targets may be between 50% and 100%higher than publicized projections. “The Street numberis a pretty good indication of what you need toearn to make up your cost of capital,” he adds.For this reason, dealmakers, if they’re playing it safe,will only focus on cost synergies in justifying a deal,leaving the revenue synergies as potential upside to berealized down the line. Revenue synergies tend to bethe assumptions that are more difficult to quantify —added earnings from economies of scale; pricing powerfrom reduced competition; and improvements inmargin resulting from best practices, among other things.Cost synergies, while bounded, are much easier topin down. It’s the overlap following a merger that canbe trimmed; the procurement costs for things such asair freight or office supplies; or costs for raw materials.“With any deal you suddenly have two data pointsto figure out who did a better job negotiating withSYNERGY continued on page 7212 MERGERS & ACQUISITIONS May 2010

OutlookSmoothing the Cost CurveStrategic buyers are looking to get ahead of commodityand raw materials volatility by pursuing ‘backwardverticals’By Jonathan Marino“The pace ofM&A activity inthe sector isalready strong.”When flat-rolled steel manufacturer SteelDynamics acquired scrap metal processorand distributor OmniSource in October of2007, the company’s CEO Keith Busse billed the dealas following through on designs to execute a backwardvertical integration. “We think it anchors our futuregrowth,” he said in the conference call announcing thepurchase.Essentially, it was a fancy way of saying that thecompany wanted to manage its raw material and commoditycosts.The timing may have been off, considering theeconomy went into freefall soon after. Today, though,analysts generally regard Steel Dynamics as among thesafer bets in the space, as the OmniSource acquisitioncoupled with the groundbreaking of its Mesabi Nuggetmining facility gives the company an evolving cost advantageand a buffer against the uncertainty of rawmaterial costs.The volatility of commodity prices in recent years,driven by fast growth in emerging markets among otherfactors, has spurred a number of companies to makesimilar bets as a way to contain costs.Russian steel maker MMK borrowed from SteelDynamics’ playbook when it acquired Russian scrapprocessor Profit last year. Profit had been supplyingroughly three quarters of MMK’s scrap consumption,according to reports.More recently, Mumbai-based Essar Group, inMarch, acquired Denham Capital’s domestic coal miningfacility Trinity Coal — a $600 million deal thatshould provide a hedge against volatile energy costs.Charles Dewhurst, a practice leader of BDO Seidman’snatural resources practice, notes that this pushto rein in commodity costs should help stimulate activityin the US. He cites that “the pace of M&A activityin the sector is already strong.”To be sure, deal volume in the natural resourcesspace is nowhere near what was seen during 2006and 2007, a two-year stretch that saw over a 1,000acquisitions completed in US, according to ThomsonReuters. But with a shade under 100 deals completedas of early April, activity is starting to percolate.The good news is that buyers may have an easiertime finding assets that provide a strategic fit at pricesthat don’t neutralize whatever cost savings they’reseeking.Take the acquisition of 475,000 acres of timberlandby paper products maker Northern Pulp Nova Scotia.The company, which is controlled by private equityfirms Atlas Holdings and Blue Wolf Capital Management,paid $82 million in March for the Nova Scotiaforest land.On its face, timber doesn’t seem like a commoditythat would have the volatility of energy or metals, especiallyas digital offerings replace print and the housingsector remains under water. However, growth inoffshore markets, the slow demise of Eastern Canada’slumber industry and a beetle infestation impactingBritish Columbia’s timber supply could conspire topush costs higher. According to a recent story in the FinancialPost, Raymond James analyst Daryl Swetlishoffanticipates a ‘super-cycle’ that could be forming forthe North American lumber markets, driven by shiftingsupply and demand trends.Considering the forecast, the $82 million acquisitionseems like a pretty smart hedge. The deal was alsofunded in part by a $75 million loan from the province,and as part of the transaction, Northern Timber sold55,000 acres of environmentally sensitive land back toNova Scotia.Another notable deal this year was Toyota’s effortto get an early jump on the lithium market, which willbecome only more important to the automaker as it producesmore and more electric and hybrid vehicles. Thecompany’s Toyota Tshusho affiliate, in January, launcheda joint venture with Australia’s Orocobre Ltd. to devel-COST CURVE continued on page 7214 MERGERS & ACQUISITIONS May 2010

OutlookBuyers May ConsiderTaking the UnderThe strength in the stock market may not prevent buyersfrom finding value among public stocksBy Ken MacFadyen“ Hope isthe newinvestmentstrategy”In the first week of April, the S&P 500 and DowJones Industrial Average hit levels unseen in roughly18 months, as upbeat employment data providedthe latest sign to investors that the worst may be behindthem. The bullishness for stocks, however, doesn’tnecessarily preclude acquirers from bargain hunting, assome deal pros believe in the current environment —marked by rising share prices and looming questionsover financing — ‘takeunders’ could become a morecommon sighting.Wit Derby, a managing director at FTI Consulting,is among those anticipating more deals in whichthe takeout price falls below public valuations. Whilethese transactions invite second guessing, the reality isthat for many companies options are limited.“Hope is the new investment strategy,” Derby says.“If you talk to CFOs and CEOs, top line growth isstill extremely weak at best. Few are seeing any materialearnings growth, and most recognize that downthe road the cost of capital is climbing.”He adds that with the government now backingout of the markets, underscored by the Treasury’s announcedplans in March to unload its stake in Citigroup,capital is only going to become more expensive.The looming refinancing cliff, in which roughly$770 billion in leveraged loans will come due by 2015,according to Fitch, may leave companies with no alternativeother than to find a buyer, even if the sale pricerepresents a discount to the market valuation.This was the option facing InfoGroup in March. TheOmaha, Nebraska-based consumer database provideragreed to a roughly $460 million deal, valuing the company’sstock at $8.00 a share. Private equity firm CCMPCapital Advisors, the buyer, submitted the best offer,which came in under InfoGroup’s share price, openingat $8.16 a share on the day the deal was announced.One buyout executive, a managing director at a WestCoast firm, notes that when it comes to takeunders, oftentimesa significant shareholder is driving the sale process.UNDER continued on page 18Quick Hits from THEMIDDLEMARKET.COMAngeleno Group Nears Final CloseAngeleno Group is nearing a final closeon its third fund, corralling $200 million of atargeted $250 million, according to a Securitiesand Exchange Commission filing. Thefirm, which tapped placement agent ProbitasPartners to market the fund, describes itselfas a sector-focused, stage-agnostic alternativeenergy and clean tech specialist. Los Angeles-basedAngeleno was formed in 2001by Yaniv Tepper, previously an institutional investmentmanager at Aetna, Daniel Weiss, anattorney at O’Melveny & Myers, and ZebRice, who previously oversaw News Corp.’sin-house venture capital group. The fund hasreceived commitments from the likes of TheLos Angeles Fire & Police Pension Systemand The Los Angeles City Employees’ RetirementSystem. Angeleno’s investment palateextends from early-stage financings togrowth equity and buyouts. The firm, for instance,in 2007, paired off with RockportCapital Partners for a Series C financinground in wireless sensor manufacturer EkaSystems. A year earlier, it teamed with GFIEnergy Ventures to acquire GT Solar Inc. Onits website it lists clean transportation, emissionscontrol, energy efficiency, power infrastructure,renewable energy, waste management,solar and wind among its target sectors.A call to the firm was not immediatelyreturned by press time.Gores Takes in Over $1BThe Gores Group nearly eclipsed the sizeof its second fund, holding an interim close of$1.04 billion for Gores Capital Partners III.The fund launched its fundraising effort lastMarch, according to a filing with the Securitiesand Exchange Commission.A target was not identified in either of theGORES continued on page 1816 MERGERS & ACQUISITIONS May 2010

Outlook“Boards mayignore wherethe stock istrading if itmakes senseto go private ata lower price”UNDER continued from page 16“Boards may ignore where the stock is trading if itmakes sense to go private at a lower price,” the sourcesays. “At the end of the day, though, boards may approvea sale, but ultimately shareholders have the final say.”It’s worth noting that in the case of InfoGroup, VinodGupta, the company’s former CEO and owner ofmore than a third of its stock, reached a settlement withthe Securities and Exchange Commission just days afterthe deal was announced. As part of the settlement,Gupta agreed to pay $7.4 million related to charges thathe siphoned money from the company during his timeas CEO. Some might consider him a motivated seller.Meanwhile, even as class action lawyers may seekto litigate these deals, a takeunder doesn’t always implya sweetheart deal. The sale of InfoGroup, for example,followed what appeared to be a thorough process.According to the company’s proxy statement, Evercorewas tapped to run the auction, which kicked off inOctober of last year, when 30 parties signed NDAs to lookinto a possible acquisition. A month later 10 financialbidders offered preliminary proposals, with additionaloffers trickling in throughout November from both strategicand private equity buyers. With final bids due in February,the board received three offers, the largest of whichcame from CCMP, originally valued at $8.40 a share.The bid, however, was subsequently trimmed after itslender revised the terms of its commitment letter, citingInfoGroup’s recent performance and modifications tothe definition of adjusted Ebitda. The two sides eventuallysettled at $8.00 a share, with a “go-shop” provisionthat failed to generate any topping offers.While rare, takeunders are not new. Novartis acquiredthe 58% stake in Chiron that it didn’t alreadyown in 2006 at a discount to the target’s share price.ChevronTexaco’s acquisition of Unocal in 2005 alsoqualifies, after its takeout price came in below an arbitrage-ledrun-up of Unocal ahead of the deal. Last year,IPC Holdings agreed to acquire Max Capital in a takeunder,although ironically it was IPC’s shareholderswho voted against the acquisition following an offer forIPC by rival insurer Validus Holdings.Most recently, analysts speculated that Palm Inc. couldbe the latest “takeunder” target after a lackluster earningscall in March. Kaufman Brothers analyst Shaw Wu, in aresearch note found on Thomson One Analytics, outlinedthree scenarios, floating the possibility that Palmcould raise more capital, it runs out of money, or gets acquired,adding the caveat that it “could be a take-under.”The problem facing Palm is the cost of capital, asthe company, as of press time, had $591 million incash and short-term investments, but was burningthrough its funding with losses amid weak sales andhigh R&D and marketing costs. Analysts at CanaccordAdams took a harsher view, reiterating a “sell”recommendation and slashing its price target on thecompany’s shares from $4.00 to $0.00.FTI’s Derby notes that the takeunder trend extendsbeyond the public market, noting that many of the buyoutsinked between 2005 and 2007, if forced to sell,would be lucky to receive valuations on par with whatmight be considered fair value. Again, he points to thegrowing cost of capital and the impending refi cliff.“You’ll see 16% new money taking out 3% existingmoney,” he says, adding that if performance doesn’t significantlyimprove, “companies in the future will beworth significantly less than what people paid.”Quick Hits from THEMIDDLEMARKET.COMGORES continued from page 16two filings, although a source confirmed thatthe firm was targeting $1.5 billion.Founded by Alec Gores in 1987, TheGores Group only raised its first blind pool ofcapital in 2003, taking in $400 million for itsdebut fund.The firm, formerly known as Gores TechnologyGroup, initially built its reputation onthe back successful tech and telecom turnarounds.In 2005, it changed its name to TheGores Group to reflect a more varied industrypalate, although stayed true to its focus onunderperformers.Recent investments include acquisitionsof Stock Building Supply Holdings, completedlast year, and 2007 buyouts of Tyco’s ElectronicsPower Systems business and vehiclelogistics company United Road.The new fund will charge a managementfee of 1.85%.Lee Equity Goes out for PizzaLee Equity Partners bought CharlesbankCapital Partners’ Papa Murphy’s, bringing tothe PE firm a pizza play at a time when lessexpensive consumer food items are beingsought by financial buyers.Terms of the deal were not disclosed andthe private equity firm declined to comment.Papa Murphy’s continues to open newfranchise locations in the Southwestern andSoutheastern US.In 2004, Charlesbank Capital Partners recappedPapa Murphy’s and since then itssystems-wide sales have increased morethan 60%.Thomas H. Lee, president of Lee EquityPartners, said the deal will result in the company’sexpansion to “areas of the countrywhere they have little or no presence.”18 MERGERS & ACQUISITIONS May 2010

LBO WatchGrowth SpurtNeed meets opportunity, as sponsors target growth equityBy Danielle Fugazy“Owners don’twant to mortgageup theircompaniesanymore.”In years past, the typical private equity firm turnedits nose up at a minority investment. Sponsors, byand large, wanted the controlling stake and sellerswere only too happy to accommodate them at the valuationsinvestors were willing to pay. It’s a differentballgame today, however, and PE firms and sellers havebeen turning to growth equity to fill in the gap.It’s no surprise, given the depressed valuations, thatsellers are turning to partial realizations as an option untilmarket conditions improve and a full exit at a desirableprice is possible. “A lot of companies that were slatedfor full-blown auctions have turned into minoritydeals,” says one investment banker, speaking anonymously.“The thought is to take out some money now andfully exit the company when the market comes back.”It’s a compromise that aligns interest for both thetargets and the investors funding their growth.In a lot of ways, the prevalence of growth equityplays has been driven in part by the limited partnercommunity, a base of investors that is no longer interestedin financial engineering as a strategy.TA Associates, which recently raised $4 billion for itslatest fund, TA XI, has always offered growth equity financingas part of its offering. The firm, though, detected an evenstronger appetite for minority investments from its limitedpartner base when it raised its most recent vehicle.“When we do a growth equity investment, we growthe company organically, not through cost cuttings orengineering. It’s real growth,” Brian Conway, a managingdirector at TA Associates tells Mergers & Acquisitions,adding that the limiteds are “less interested inthe mega funds” that seemed to dominate the lastfundraising cycle.In addition to LP interest, business owners seem toprefer the strategy as well, at least in the type of marketexperienced over the past 18 months. Sponsors realizebusiness owners aren’t too keen on selling at abottom. As a result, the number of private equity firmstrying to raise growth equity funds has soared. Thereare 130 growth capital funds seeking to raise $27 billion,according data provider Preqin. That’s significantlyhigher than the 51 growth capital funds thatraised $11.6 billion in 2007.Conway notes that he is seeing more traditionalgroups target minority investments as well “becausethere is less leverage available.”3i Group is one such firm that is becoming more activein the segment. In March, the firm closed its new z1.2billion Growth Capital Fund, which will invest throughoutEurope, Asia and North America. Overall, the fundwill focus on investments between z25 million and z150million. 3i recently made its first investment out of thenew fund, taking a 20% stake in Refresco, a Netherlands-basedjuice manufacturer, for z84 million.Christopher Russell, a managing director withVeronis Suhler Stevenson, agrees that the level of competitionin the growth equity segment has increasedsince VSS first began pursuing minority deals. “A lotof traditional funds are being more opportunistic andtrying to do minority deals,” he describes.With that said, Russell doesn’t necessarily believethe transition is as smooth as some groups may assume.“It’s not that easy when you are used taking control,”he adds. “You try to get a board seat and a voice,but it’s not the same as when you own a company...some firms have a hard time with that.”VSS recently closed its second fund that has theflexibility to pursue growth plays. VSS Structured CapitalII closed with $312 million in December. At theend of March, VSS provided Hostway Corp., a webhosting and cloud computing provider, with a growthequity investment. The transaction was led by VSSalong with Fortress Capital, Regiment Capital andPhoenix Life serving as co-investors. The total commitmentwas $110 million in debt and equity financing.Specific terms of the deal were not disclosed.The investment, in a lot of ways, also speaks to theopportunity for buyout shops, who are ironically ableto fill in for investments that might otherwise go to alender in more liquid times.“Growth capital can be used to finance acquisitions,develop new technology and grow businesses,”says Russell. “Owners don’t want to mortgage up theircompanies anymore.”20 MERGERS & ACQUISITIONS May 2010

Debt MonitorJunk Debt Markets CouldAbsorb LBO RevivalHigh yield market builds even more momentum, althoughhow it supports PE will differ from years pastBy Matthew Sheahan“ This wholeamend-andextendtrendhas kicked thecan down theroad.”The leveraged loan and high yield bond marketshave seen a slow but steady increase inM&A related debt coming to market, and theycould absorb an influx of M&A and LBO-sponsoreddeals if a significant comeback were to happen, sourcessay. But while investors are thirsty for debt deals of allkinds, the LBOs of 2010 will look quite different fromthose of 2006.“The market’s probably able to absorb a lot becausefund inflows have been strong, and that’s indicativeof inflows in other sectors as well,” says MartinFridson, CEO of Fridson Investment Advisors.So far this year, investors have poured about $2billion into high yield bond funds, according to LipperFMI. Junk bond funds took in a total of just over$20 billion last year, the largest year on record for highyield bond inflows since 2003. “The demand for highyield debt is pretty strong,” Fridson observes.Researchers at Bank of America Merrill Lynch concurthat market conditions are ripe to spur an LBOrevival. “The combination of credit market resurgenceand tight spreads, attractive equity valuations and ampleprivate equity ‘dry powder’ create the conditions forincreasing the volumes of LBOs,” BofA analysts saidin a recent report.But the same report notes that there are size andstructural restrictions on today’s LBOs that weren’tpresent before. “Unlike the most recent era, lower leverageand more prevalent change-of-control protectionshelp to limit cram down losses,” the BofA analysts said.Investment bankers and analysts agree that the currentmarket favors middle-market deals, and the megadealswith high leverage sit in the same ash heap of historyas dot-com pet food companies.Of course, the high yield market has its own viewof what qualifies as middle market. The BofA reportcites IMS Health as a case study of what new LBOdeals will look like. The Norwalk, Conn.-based pharmaceuticaldata provider accepted a $6 billion buyoutoffer from TPG Capital, the Canada Pension Plan InvestmentBoard (CPPIB) and Leonard Green & Partners,who together put up $2.8 billion in equity andcash for the deal. Goldman Sachs syndicated a $2 billionterm loan and $1 billion in 12.5% senior securednotes due 2018. The IMS deal saw the banks and mezzanineinvestors provide debt where CLOs would normallyhave stepped in, the report pointed out.“The wildcard in our analysis is the economy andthe rebirth of the CLO market,” says Darin Schmalz,a director with Fitch Ratings.“We are unlikely to see $700 billion-plus of loan issuanceanytime soon as we did in 2005 to 2007, butwe could see more than $300 billion for a couple years,”Schmalz adds. “The $300 billion-plus of issuance wouldaccommodate a good amount of M&A activity.”For the past 12 months, nearly all of the deal flowon the leveraged loan and high yield bond markets hascome from refinancing deals, and sources expect thesedeals to comprise a significant portion of deal flow in2010. Fitch Ratings projects that approximately 45%of all leveraged loans issued this year will be used forrefinancing, according to a March 22 report from therating agency. However, when the expected refinancingcliff is at its peak, between 2012 and 2014, thatpercentage could rise to between 60% and 75 percent.Still, M&A activity has been making a rebound,with strategic buyers finding a friendly reception inthe speculative-grade debt markets. Whether or notinvestors find LBO debt to be attractive though is anothermatter. Almost half of US nonfinancial companiesthat defaulted last year were private equity portfoliocompanies, according to a Moody’s InvestorsService report.JUNK DEBT continued on page 7222 MERGERS & ACQUISITIONS May 2010

Private equitysponsorsstruggle tomake senseof the newfundraisinglandscapeBy Danielle Fugazy24 MERGERS & ACQUISITIONS

In 2008, most private equity investors had a sense that themarket was tightening. Few, however, would have consideredlaunching a fund if they knew what actually awaited themin September of that year.As it turned out, many of the fundraising efforts launchedin the first half of 2008 were put on hold indefinitely. Only now,perhaps as many as two years after a Form D was originallyfiled with the Securities and Exchange Commission, are sponsorsPinchedCover Photograph by Jeffrey Coolidge / Stone / Getty ImagesMay 2010

Pinched“There is a bigshake outgoing on andit’s going toleave someprivate equityfirms out ofbusiness.”returning to the market to try to generate interest forthese ‘new’ funds. Today’s environment, however, bearsno similarity to the landscape sponsors thought theywere entering in 2008.Two years ago, fundraising was a momentum business.Secure a cornerstone investor with some juice ina first close, such as a CalPERS or an Ivy League endowment,and the toughest part of the remainingfundraise was limiting the allocations of the other institutionalinvestors that wanted in.These days, a first close is every bit as important,but each subsequent commitment a sponsor receives,for the most part, is just as difficult to procure thereafter.According to one placement agent, the averagetime it takes to raise a fund, 18 months, is twice aslong as the average duration seen in 2004 through2009.Moreover, sponsors are suddenly unsure about whatis considered market regarding fund terms and whetheror not hiring a placement agent will be held againstthem following the pay-to-play scandal that is still unfoldingin certain jurisdictions. For a constituency thatgenerally loathes this part of the business to begin with,fundraising has become even more of a headache thanany sponsor likely remembers.“It’s been a year and half since Lehman went bankruptand people are minimizing where we are. Thereis a big shake out going on and it’s going to leave someprivate equity firms out of business,” says The RiversideCo.’s Stewart Kohl, a co-founder of the firm.“Fundraising is harder than ever. It might be the mostdifficult time since dinosaurs roamed the planet.”Riverside, it should be noted, closed its most recentfund, Riverside Capital Appreciation Fund V, last yearat $1.17 billion, above its original $900 million target.Kohl, one might assume, had a much easier timethan the other 1,500-plus funds data provider Preqinhas tallied that have been out fundraising over the pastyear.The biggest change, according to Kohl, beyondjust the time it took to raise the fund, was the depthof limited partners’ research prior to making a commitment.He also noted that the makeup of the limitedpartner universe has changed drastically and that manyof the firm’s existing LPs were unable to re-up for thenew fund.“Our goal was to broaden our gene pool. It was amatter of desire, but then it became a necessity,” hesays. “Some of our closest, best standing LPs didn’thave the liquidity. It was disappointing, but we had tocontinue to raise our fund.”Beyond a strong performance, Riverside’s differentiatedstrategy helped set the firm apart. Riverside isdevoted to the smaller end of the middle market, with19 offices in 13 countries, including an office in HongKong designed to help its portfolio companies tap intothe Asian market. The firm is also currently raisingthree additional vehicles — a micro-cap fund, an Asianvehicle and fund dedicated to opportunities in Europe.While the differentiated strategy didn’t necessarilymake it easy for Riverside to raise its primary vehicle,it was a difference maker in terms of the firm’s abilityto attract capital. Other firms who have foundsuccess in this market have also done so on the back ofa differentiated platform.DRI Capital, for instance, invests in drug royaltystreams. It’s as specialized as a fund can be. LPs were apparentlyintrigued, as the firm closed its second fundroughly $200 million over target at $701 million.Meanwhile, segments of the market that saw anumber of firms rush into a particular space have hada harder time attracting capital. Blackstone Group andKohlberg Kravis Roberts, for instance, experiencedenough headwinds trying to raise their respective infrastructurefunds that each lowered their carry on thevehicles to 10 percent.Anecdotally, limited partners are also targetingfunds that can work in this particular environment.Operations, for instance, are key, but some of the moresuccessful fundraisings in recent years belong to firmswho can just as easily execute a distressed play as a traditionalLBO.Marlin Equity, which specializes in targeting trueout-of-favor sectors and companies, had to turn away$1 billion last year when it hit its $650 million hard capfor its third fund. Littlejohn & Co., another operatorwith a track record, seems to be making quick work ofits fourth fund. The firm held a nearly $400 million firstclose in September and followed up two months laterwith a second, closing on $616 million of a targeted$1.323 billion. The firm’s predecessor fund closed on$850 million in March of 2007.While it’s the success stories that people hear about,far more common are the situations marked by uncertainty.Indeed, even some of the most well known firmshave had problems raising new funds. Candover Investments,which had been marketing a a3 billion fundsince 2008, finally pulled the plug on its effort at thebeginning of this year after raising just a sliver of whatit had hoped to bring in.Madison Dearborn Partners set out to raise a $10billion fund in 2008. The fundraising process has beenanything but smooth for the Chicago-based firm. Asrecently as January the firm amended the terms of its26 MERGERS & ACQUISITIONS May 2010

fundraising agreement so it could continue to raise capital until theend of April. The final close for the firm’s sixth fund was supposedto be February 1, but LPs wanted additional time for due diligence,according to reports. The vehicle, as of press time, had closed onroughly $4.1 billion. It’s a substantial sum, but still a far cry from theoriginal $10 billion target and will require a significant jump to hitthe lowered $7.5 billion goal.Just how tough the market was last year is reflected in the totalvolume of funds raised. According to Dow Jones LP Source, a totalof $95.8 billion was raised by 331 US-based private-equity funds,down 68% from 2008 and the lowest total since 2003. Meanwhile,globally, data provider Preqin tallied worldwide volume to be $246billion, raised by 482 funds last year.In the first quarter, meanwhile, Preqin documented a slight improvement,showing 79 fund closes, amassing $50.4 billion in totalvolume.The good news, at least for firms in the middle market, is that thebarbell theory — emphasizing outsized mega funds and small-marketvehicles — is no longer driving commitment decisions from institutions.As the Marlin and Littlejohn funds demonstrate, it’s the middlesizedgroups that can spur change who are achieving favored statusamong limiteds today. The challenge, though, is actually proving outan ability to proactively alter and augment performance of acquiredcompanies.The Sterling Group, for instance, just closed on $820 millionfor its third fund. Kevin Garland, a partner at the firm, concedes thatgetting to the finish line was tough. He notes, though, that an alteredstrategy was what ultimately helped the firm exceed its original$600 million target.The Houston-based firm has always been operationally focused.That, however, means little to limiteds who hear such claims from everygeneral partner who knocks on their door. It wasn’t until Sterlingput together a presentation to demonstrate exactly how it drives operationalimprovements that the new fund started to gain traction.Just having a CEO or six sigma blackbelt on speed dial doesn’t workanymore.“We had to really show them our play books to capture their attention,”says Garland. “The real-life materials are what made thedifference.”Like Riverside, Sterling saw some existing investors not return,but the firm added 10 new institutions to its LP base. What mightbe most notable, given much of the debate in fundraising circles today,is that Sterling raised its fund without significantly altering theterms from previous vehicles.PINCHED continued on page 70

Emerging Managers’Catch 22The market is ideal for funds that don’t have a legacyportfolio; LPs, though, are hesitant to back a team withouta track recordBy Ken MacFadyen“ It alwaystakes longerthan anyoneexpects toraise a fund.”This should be a perfect market for emergingmanager private equity funds. A legacyportfolio, in many cases, is viewed as abad thing considering the rehabilitationwork facing most general partners. Moreover,the credit crisis exposed weaknesses in a numberof strategies, opening the door for new groups with adifferentiated approach. The catch, though, is that thebar has been raised so high that only a few have managedto raise first-time funds since the dynamics of theindustry shifted in their favor.Shad Azimi, founder and a partner of fund-offundsVanterra Capital, notes that currently he is seeingno shortage in the supply of candidates. Azimi anticipateseven more will materialize, whether its drivenby need, dissension among partnerships, or successionissues in which rising stars see little chance of cleavinga spot within the founders’ circle. However, he estimatesthat as many as 70% of the new groups whosePPMs cross his desk will never raise a fund.“The threshold for managers is just so high,” he says.It’s never been an easy road for first-time funds.But the fortunes of new groups often run parallel to thebroader fundraising market. When Centerbridge Partnerswas formed in 2005 by Blackstone Group’s formerhead of private equity Mark Gallogly and Angelo Gordon’sex-distressed investment head Jeremy Aronson,the pair trotted to a $1.8 billion first close for the inauguralfund. Soon after, Centerbridge held a finalclose on $3.2 billion, turning away a bundle of cash inthe process, even as it exceeded an original $2.5 billiontarget.Today, fundraising for all funds is a much more arduousprocess. The new groups, though, face evenmore scrutiny. This seems to belie the fact that so manyinstitutional investors have set up programs specificallytargeting emerging managers. Illinois Teachers RetirementSystem, the New York Common Fund, andCalPERS, to name just a few, have all allocated millionsspecifically for emerging managers. Morgan StanleyInvestment Management, in January, launched its ownemerging manager program. This attention may giveoff a false impression for people considering launchingtheir own shop.“Institutional investors are even more skittish aboutnewer funds,” attests Marcellus Taylor, who acquiredUnited Investment Managers last year, and now servesas chairman and CEO of the asset manager.Joshua Vogelhut, a partner at global placementand advisory agency Atlantic-Pacific Capital, adds,“Prospective limited partners are going to go througha tremendous amount of due diligence before they arecomfortable.”In the past, the diligence may have focused on thekey partners’ track records. Attribution is no less importanttoday, but limiteds, perhaps a nod to Bernie Madoff,are going much deeper in their background checks,which will include calling on references both on and offthe lists prospective GPs provide. The cohesion of theteam is important too, although today limiteds are asinterested in how firms man the junior positions andback office as they are in the names that may go on thedoor. They want to know about the good deals, to be sure,but it’s likely the bad investments they’ll place the mostemphasis. And GPs shouldn’t cherry pick their trackrecord. One limited said as a rule, they won’t commit toa firm if they find the sponsor “overlooked” a dud.Perhaps most important, LPs will expect GPs tohave a strategy and process in place and be able to provethat an identifiable source of dealflow exists. Basical-28 MERGERS & ACQUISITIONS May 2010

ly, limiteds are targeting emerging managers who areevery bit as established as a “Roman numeral” GP thatmay be on its fifth or sixth fund.Other factors make it even more difficult for newgroups. Limited partners, for instance, want to see GPsmake commitments to the fund to ensure interests arealigned. For a first-time vehicle, which has yet to secureany management fees, the partners already need tohave the financial wherewithal to live without a salaryfor what can be an extended period of time.“Even in a very hot fundraising market, it alwaystakes longer than anyone expects,” says Jose Fernandez,a managing director at institutional investment adviserStepStone Group. “The stars may assume that they’llhave immediate backing, but they should be preparedto go perhaps two years without any income. That’ssomething we’ll look at; whether the team has the staminato make it through those first couple of years.”All of these factors are evident in the groups that havesucceeded in raising first time funds in the past few years.Huntsman Gay Global Capital, in 2009, lockeddown $1.1 billion for its debut vehicle. Before LPscommitted, however, Jon Huntsman and Robert Gayhad already assembled a team that collectively had investedin over 200 different deals.Gay, a veteran of Bain Capital and a seed investorin Sorenson Capital, recruited the likes of GregoryBenson, Richard Lawson, Ronald Mika, Judy Frodigh,Rhett Neuenschwander and Steven Young, all of whomhad spent time either at Bain or Sorenson.StepStone’s Fernandez cites that cohesion among thepartners can be as important as the track record of theinviduals. “You ideally want a team that has been togetherfor years and has proven they can work together,”he cites.Moreover, the general partnership of HuntsmanGay staked over $100 million of their own money inthe fund, a sign to the limiteds that the partnershipbelieved in the strategy they were selling to prospectiveinvestors. The partners collectively represented the secondlargest investor in the fund behind only CalPERS.Pine Brook Road Partners, led by former WarburgPincus vice chairman Howard Newman, was anothergroup that raised a first-time fund last year, corralling$1.43 billion. Like Huntsman Gay, the firmhad a full team in place, with an infrastructure that“ If you spend alot of time onexplanations,you can loseyour audiencepretty quickly.”

likely surpasses many similarly sized vehicles.Huntsman Gay and Pine Brook Road were formed in 2007 and2006, respectively, underscoring the time it takes for even the biggestnames to raise a first-time fund.Joseph Gantz, managing director and chief operating officer atPine Brook Road, notes that one of the keys for the firm, beyond adifferentiated strategy, was having everything in place.“One of the things we told limited partners was that we’re hereto build a firm, not raise a fund,” Gantz says, identifying that in thethree years between the firm’s launch and the final close, Pine BrookRoad honed its strategy, built its back office and refined its processes.The result was that the GP had a clear story to tell potential limiteds.A core part of that, following a few initial investments, was theearly makings of a portfolio, which demonstrated exactly how thefirm’s partners could function as a group.Pine Brook Road, similar to Warburg Pincus, takes a line of equityapproach in its investment thesis, backing management teamsincrementally in a way that moderates risk but allows the firm togain control stakes in growth businesses.Unlike Huntsman Gay, the team comes from more disparatebackgrounds. Gantz, for instance, has corporate experience, havingserved as a CEO at Empire Brushes, Fitz & Foyd, Seymour HousewaresCorp. and other companies. Other partners include Craig Jarchow,who came from First Reserve Corp., The Cypress Group veteranWilliam Spiegel, and former JPMorgan Partners’ former chiefinvestment officer Arnold Chavkin.With a portfolio already in place, Gantz notes Pine Brook Road wasable to answer questions about cohesion. “The strategy was important,but it was critical that we were able to point to concrete examples— not from our past experience — but in our portfolio,” he says.This is a likely differentiator today separating the emerging managerswho can attract capital and those who can’t.Among the more attractive nascent groups currently on the marketis Atlas Holdings. The firm filed with the SEC in December tolaunch its debut third-party fund. Initial press reports pegged the targetat $300 million, but the firm, according to the filing, is seeking amore ambitious $350 million, likely on the back of robust demand.Atlas was formed in 2002 by Pegasus Capital Advisors veteransAndrew Bursky and Timothy Fazio and since then has established asuccessful track record executing turnarounds, rollups and leveragedESOP transactions.Taylor notes that the depth of the newer groups speaks to theevolution of the asset class. “The days of a couple guys hooking upand hanging a shingle before raising $100 million is not applicableanymore; not after the challenges institutional investors have facedover the past couple of years.”That, in turn, leads to the question of where the next era of emergingmanagers is going to come from. In the past, the market wouldrush to greet new offerings from people striking out on their ownfrom the largest firms. Bain Capital, Blackstone Group, GoldmanSachs, Kohlberg Kravis Roberts, and Thomas H. Lee Partners havespawned many of the better-received new funds during the pastdecade. Bain DNA, for instance, can be found at Audax Group,Golden Gate Capital Partners, Huntsman Gay, Tokyo’s AdvantagePartners, and Australia’s Pacific Equity Partners. Even Solamere Capital,which recently closed its inaugural fund-of-funds, likely hadhelp from the firm’s association to Bain founder Mitt Romney. Hisson, Tagg, founded the firm.In the future, however, it’s going to be harder and harder for thesoldiers in private equity’s ‘bulge bracket’ to attract capital. The primaryhangup goes back to attribution, as it would be nearly impossiblefor LPs to decipher who is responsible for a deal that may havehad 30 different people from multiple firms working on it.“If you spend a lot of time on explanations, you can lose your audiencepretty quickly,” one observer cites.Azimi adds that for many of the larger funds, “The name getsthem the deal.” KKR, for instance, is probably a first call for bankersshopping an asset with hopes of fetching $5 billion or more. Additionally,Azimi cites that candidates from the mega firms have an institutionalmentality. “It’s just a different way of investing than thescrappy smaller shops that are pulling in proprietary deals,” he adds.The next era of emerging managers will likely come from midmarketshops. Azimi, whose firm Vanterra will even seed emergingplatforms and at times will invest in the general partnership, expectsthat new groups, with an identifiable specialty, will emerge out ofthe more generalist funds.One firm Vanterra backed was Cressey & Co., after Bryan Cresseyleft Thoma Cressey Bravo in 2007 to focus exclusively on healthcareinvestments. Azimi notes that such a concentration makes it easierto parse a track record and get a sense of who did what. It also helpsthat Cressey left on good terms, eliminating the kind of spat that oftenbreaks out between two firms over attribution.Observers also anticipate asset managers of family offices couldsee interest. The team is often in place and limiteds can get a senseof the investment process before committing money. FdG Associatesand Oak Hill Investment Management are among the more successfulgroups to come from this area.Then there are the pledge funds that may be operating on a dealby deal basis. This was how Atlas Holdings built its track record,which is serving the firm well now that it’s in the market. Investorscite that for firms unable to attract institutional interest, this may bethe best option.For many, however, the timing is tough, as most recognize thatthe fundraising market is effectively closed for a lot of groups outthere. Also, given the slowdown of investment activity, many are likelystill waiting until the end of a fund cycle at their current firms beforemaking the jump.But the attraction to emerging managers endures, even if limitedsare slow to pull the trigger. As one advisor cites, “The conventionalwisdom is that the first and second funds tend to be the best performers.I think there is some truth to that, as long as you’re backing theright group, because that’s when they’ll be motivated and hungry.”The caveat, as the source alluded to, is that LPs want to makesure that they’re investing in the right group.30 MERGERS & ACQUISITIONS May 2010

Q&ABad Blood?Coller Capital’s Luca Salvato discusses the state of GP/LP relationsBy Ken MacFadyenRelations between general partners and the institutions thatprovide them backing have seemingly never been worse.Limiteds, stung by losses and emboldened by a shortageof capital in the market, have sought to regain someof the ground lost to sponsors during the bubble. WhenThe Institutional Limited Partners Associationissued its guidelines last September, the15-page document initially caused little stir.As soon as the private equity firms realizedthat LPs, by and large, were reading the materialand using it to guide their discussions,it became a bit more personal.The Wall Street Journal, in March, reportedthat three large funds had even broughtin antitrust counsel to explore possible collusion.Then there was the much heralded sitdowninvolving the heads of CalPERS andother top LPs and top names in PE.While it all makes for an interesting storyline, Mergers & Acquisitions caught up withColler Capital partner Luca Salvato in Aprilto discuss the state of GP and LP relations.Salvato, who sees it from both sides, doesn’tquite buy into the drama. He notes that ashift in power has occurred, to the benefit ofthe limited partners, but any dissension isjust a normal course of negotiations during Luca Salvatoany cycle.The following is an edited version of the April conversation.Mergers & Acquisitions: What’s your initial take on the debate that seemsto be building steam between the limited partners and GPs?Salvato: I think ultimately this whole discussion is a move by bothsides toward self regulation. It’s a positive for the industry at largeand ultimately a sign of an asset class that continues to mature. TheILPA is trying to present a list of guidelines on a broad gamut ofthemes, which include areas such as governance, terms, transparencyand how GPs communicate with their LPs. It’s not intended to establisha cookie-cutter approach. In any negotiation between limitedsand general partners, there will be elements that are applicable,but across the board there will be some nuances that aren’t.Mergers & Acquisitions: LPs have published best practices before. Whyis this such a big issue now? Does it reflect that LPs finally have the swayto see some of these things through?Salvato: There are always shifts in the powerbalance, which is effectively just a supply anddemand dynamic. It’s hard to generalize, butthere has clearly been a shift toward limitedpartners in the last two years. From a fundraisingperspective, last year there was a draughtand this year, so far, fundraising has been veryslow.You have a significant number of GPs chasinga limited amount of capital. Whenever thatis the case, it gives the LPs more power to dictatethe terms. Notwithstanding that, though,the limited partners are very keen to invest withthe highest performing GPs — groups that ina lot of cases have a strong track record andmost likely have already adopted most of thebest practices LPs are seeking.It obviously varies depending on the situation,but generally in cases where the GPsdon’t have the track record and maybe haven’tbeen around as long, the limited partners aremore readily able to dictate those terms.Mergers & Acquisitions: What are some of the things that LPs are targeting?Salvato: In addition to terms, governance issues appear to be an areathat is getting a lot of attention. Things like key man clauses, escrowwith regards to the carry, transparency and reporting standards are allareas being discussed. The increased dialogue on both sides is a positivething for the industry and helps reaffirm the idea of it being atrue partnership.Mergers & Acquisitions: As it relates to terms, have you seen a shiftfrom the standard two and 20, with a seven or eight percent hurdle rate,32 MERGERS & ACQUISITIONS May 2010

Q&Aor is it more about renegotiating with the firms that instituted higher carryor management fees to get them back to historical levels?Salvato: It’s really hard to define. What is considered ‘market’ reallydepends on the individual situation. Ultimately investors havethe choice about whether or not to invest. It’s a natural selectionprocess with each GP, so it’s hard to classify what is or isn’t a standardterm.Mergers & Acquisitions: What about as it relates to side letters? AreGPs being pushed on an individual basis to provide the same terms andagreements to the varying LPs within a fund?Salvato: I think that’s part of the transparency discussion.Mergers & Acquisitions: Coller publishes a barometer gauging issues impactingLPs and GPs. In the most recent survey, reporting was one of theareas identified where LPs were seeking improvement. What exactly arelimiteds looking for?Salvato: Ultimately, LPs just want a level of information that allowsthem to satisfy their own requirements and reporting standards. Thepublic pensions face their own scrutiny, so they’re looking for transparencywhen it comes to reporting on the underlying companies ina portfolio and things like that.Mergers & Acquisitions: Conflicts of interest was another area discussedin the barometer. Where do some of these conflicts tend to emerge?Salvato: Limited partners are looking for alignment between thegeneral partner and LP. This may take the form of how carry is structured,whether it’s line by line or on the fund level, whether firms formmultiple vehicles, and then just continuity within the organization.Mergers & Acquisitions: We’ve discussed transparency and reporting tosome detail. What is expected on the part of GPs?Salvato: When I think about it, it’s more about the information flowand the level of information being reported. It’s an active dialogue withGPs, not only about current investments, but what they’re thinkingwith regards to their investment pace going forward and what risksthey may face in the market.It all depends on the strategy of the GP and whether or not aquarterly update makes sense or not. It’s very case by case, but I don’tthink I’ve ever heard of a GP overburdening limited partners with information.Mergers & Acquisitions: Is there a risk that with an open dialoguethere will be more situations similar to what we saw with Permira andOPER’s reaction to the job cuts at its portfolio company, Hugo Boss? WillLPs take more of an activist approach to situations involving what mightbe considered their key constituencies?Salvato: There will always be situations that arise that might qualifyas a one-off incident or an outlier, but I don’t think that would necessarilybecome a more common theme with an increased dialogue.Mergers & Acquisitions: What about return expectations? What’s consideredtop quartile today?Salvato: That changes all the time. The market goes through cyclesconstantly. LPs are really looking for returns commensurate with therisk that they’re taking by investing in the asset class.Mergers & Acquisitions: You mention the perception of risk; givenwhat’s happened over the last few years, do LPs perceive the asset class tobe a riskier place to invest? Are some maybe a little more hesitant to backa blind pool?Salvato: The long-term investors, people who have been around fora while, are very aware of the risk profile of the asset class. If youlook at the investors who came in during the past 10 years, and haven’tbeen through a true cycle, their views have maybe changed. Privateequity, though, is obviously not the only asset class that has been impactedduring the last few years.Mergers & Acquisitions: One of the themes that I keep hearing about isthe increased due diligence and how long it takes to raise a fund today. Whatare some areas being explored that might have been overlooked before?Salvato: There is a limited amount of capital available and LPs arelooking to ensure that they generate top-quartile returns. To that endthey’re looking to develop a deep understanding of the firms they’reinvesting in. If you ask them, though, they would say that their duediligence hasn’t changed.Mergers & Acquisitions: What’s your general take overall on the viewof private equity from the perspective of limited partners?Salvato: Notwithstanding all of the negative tone, I’m still hearingpositive feedback from LPs with respect to private equity generally.The long standing limited partners see the asset class as a key part oftheir strategy and they continue to invest and stay active in the segment.In fact, I’m seeing a lot of limited partners frustrated becausethey don’t have the capital available that they would like to deploy,especially since they’re viewing this next vintage as an opportunetime to invest.Mergers & Acquisitions: What part of the market, in particular, isgenerating interest?Salvato: It depends on the individual limited partner and where theysee value going forward. Mid-market strategies, operational experienceand a track record of generating improvements are some of thethings LPs are looking for.34 MERGERS & ACQUISITIONS May 2010

RoundtableTheRe-emergenceofLiquiditySponsored bySponsored by

Elizabeth BorowThompson Street CapitalMark CordesAudax GroupJohn CozziAEA InvestorsChristopher CrosbyNautic PartnersDevon RussellMadison Capital FundingWilliam WintererParthenon CapitalGary ZussmanGoldberg KohnKen MacFadyenMergers & AcquisitionsThe credit markets have shown markedimprovement, though dealmakers have differentviews on how the next 12 months will unfoldPhotographs by AlanfilMay 2010 MERGERS & ACQUISITIONS 37

RoundtableIt’s been a little more than 19 months since Lehman Brothers collapsed,sending the global credit market into a state of upheavalthat only recently has started to settle. For participants in the middlemarket, it’s been a slow rebuild. Dealmakers initially overloadeddeals with equity in order to stay active. Then the asset-based loanmarket opened up, while mezzanine debt helped fill in some holes. Recently,signs of life can be found in a CLO market that has up untilrecently been comatose, while senior cash flow lenders, at least thosewith secure funding, have been eager to back quality credits.“I’m convincedWall Street willfind a way; theyalways seem to.Elizabeth BorowManaging DirectorThompson Street Capital”It’s a bifurcated market, to be sure, with a split occurringbetween the targets that need to sell and thestrong companies that can. But the dearth of qualityhas translated into attractive terms that for strong credits,in some cases, may rival what buyers saw at the onsetof the bubble.Mergers & Acquisitions brought together top namesin finance and private equity in March to discuss thestate of the market and where exactly it goes from here.Taking part in the discussion were Elizabeth Borow,of Thompson Street Capital, Mark Cordes, of AudaxGroup, John Cozzi, of AEA Investors, Nautic Partners’Christopher Crosby, Devon Russell, of Madison CapitalFunding, Parthenon Capital’s William Wintererand Gary Zussman, of Goldberg Kohn. The followingis a condensed and edited version of the conversation.Mergers & Acquisitions:It seems like there are a fewpockets of strength today,such as the mezzanine andasset-backed market. On theother hand, a lot of the newsenior lending groupsformed in the wake of thedislocation have had troublegaining traction, and theCLOs, even as there is moreoptimism in this area, are afar cry from what we sawin 2007. As a jumping offpoint, what does the competitiveenvironment looklike in the debt markets right now?Russell: Well, it only takes one competitor to keep youhonest, so I would say that it’s still competitive. In themiddle market, we’ve swung back to the early 2000’s,when debt was arranged on more of a club basis.At the peak of the bubble, there were probably 20-plus competitors looking for the lead positions in deals,who were willing to underwrite and syndicate. Thatnumber is probably down to three or four, today. Butbased on the current volumes, the handful who are activeare adequate to keep lenders honest at this stage ofthe game. I’d also say that the risk of execution is diminishingdaily, but you’ll still see clients try to forma coalition and bring lenders together on one commonterm sheet.Zussman: At Goldberg Kohn, the bulk of our time in2009 went from primarily transactional work to theinverse of that, where we ended up doing a lot of workouts. Around the middle of the year, the ABL (assetbasedloan) market started to rebound and more recently,we’ve seen a pick up in cash flow deals.Borow: While people talk about the difficult financingmarkets, we actually found it very challenging on theinvestment front. There just hasn’t been a lot of qualitydeals in the pipeline. We closed one new platformlast year, and we were surprised to find that it wasn’t thatdifficult to raise financing for the deal. It’s a binarymarket; if you can find a very good deal, you’ll attractlenders, but if not, they’ll head for the hills.This year we’ve seen more lenders come back to38 MERGERS & ACQUISITIONS May 2010

the market, but the bifurcation still exists. Iactually think the technicals are so strongright now that lenders want to put capital towork. When we went out to test the marketon a handful of deals this year, we were encouragedby some very aggressive pricing,which I think is driven by the fact that therehas been a dearth of quality.Winterer: I still think there is a ways to go interms of the number of participants and overallliquidity as well as how smoothly the executiongoes. Last year, we tried to adapt tothe environment. At Parthenon, we closedtwo new platforms, which were both financialservices companies. Neither had fundeddebt at the close.For the larger deals, we’re still finding itchallenging to pull together multiple lenders.There needs to be more traction before it becomesan orderly process, but so far, the improvementover the past year has been encouraging.The key will be the macro economy. Ifthere’s continued growth there, the debt marketswill stabilize.Mergers & Acquisitions: What’s the makeupof the lender universe today in the middle market?Russell: There is cash continuing to build inthe CLOs. It’s not necessarily new CLOs comingto market, though. There are a lot of oldwarehouses that are being spun out. The goodnews is that it’s providing price discovery forthe banks.I would also say that the commercialbanks are alive and well. The emergence of theregional banks has probably been the biggestsurprise. Wherever a target company is headquartered,it’s pretty easy to find a regionalbank that will want to come into the deal.For all of the negative news you hear, the regionalbanks have actually been more aggressiveand more willing to provide leverage thananyone expected.We don’t really participate in the largemarket, but my understanding is that it’s verycompetitive among the investment banks.Based on the deals we’re seeing, they’re reallypushing the market with a much more aggressiveset of terms.Mergers & Acquisitions: Does that trickledown to the mid-market?Russell: Our market is moving; it’s just notmoving as rapidly.Pricing always moves first. In the largemarket, you’re seeing more of a melding of theloan and high yield market. Liquidity, lastyear, was much better in high yield, and nowit’s shifting back to the loan market. Therehas definitely been some migration down,but the middle market is much slower tomove on structure and terms, because for themost part it’s a buy-and-hold market.Mergers & Acquisitions: To go back to the regionalbanks, do you think they have stayingpower or are they just looking to be opportunisticright now?Winterer: That’s a good question. While we’reseeing recovery and improvement, there’s alot of uncertainty out there in terms of howthese leverage finance markets behave andwho the key principals will be in the future.If you look at this most recent boom/bustcycle, it was really the structured finance vehiclesand commercial lenders that fed into theboom and the issuance was driven by the cap-May 2010 MERGERS & ACQUISITIONS 39

Roundtable“The regionalbanks are hereto stay.Mark CordesPrincipalAudax Group”ital markets. That has obviously ended.There’s been some recovery in the CLO marketbut there still hasn’t been significant issuance. Thequestion everyone is asking is whether or not that issuancecomes back. I think it does, but it hasn’t happenedyet.In the meantime, it’s been the regional banks whoare driving much of the liquidity you’re seeing in themiddle market. I question whether or not they will belong-term players in leverage finance. I’m also curiousto see how the regulators view it. At the end of the day,it’s a risky business, so you have to wonder as regulatoryreform takes shape, if the Federal Reserve is goingto want deposit money investing in leveraged loans.Everybody, at this stage, is still trying to figure it out.When CIT went through its bankruptcy, the companystill had a lot of liquidity, but it was all tied to its Utahbank. The regulators wouldn’t let the company usethose deposits to fund the commercial finance business.So if that’s an area where the regulators are goingto be rigid, I’m not sure the regional banks will be longtermplayers in the market. At the end of the day, we’llneed to see a recovery in the CLOs in order to sustainan efficient market.Cordes: The regional banks are here to stay, but they’regoing to play the same role they have always played.They’ll be active when it comes to supporting dealsinvolving local industry or certain areas where they focus.They’re never going to drive the boom or the bust,but they’ll be around to support transactions in thelower middle market.Borow: I don’t believe all regional banks are the same.There are certain players, probably the minority, whoare very steady. They understand the business and havebeen in the business for a while. Then there are the regionalbanks who have only recently set up some sponsorcalling efforts. I don’t even think they know whattheir staying power will be.Generally speaking, we find them to be significantlymore conservative in terms of pricing and structureand very often their deals are quasi asset-based facilitieswith air balls. So we won’t lump all of the regionalbanks together. Some get the cash-flow business,and some don’t.Cozzi: To go back to Bill’s point, I agree that the wildcard with respect to the regional banks will be the impactof regulatory reform. Higher capital requirements,for instance, would certainly affect a regional bank.Mergers & Acquisitions: To follow up on another pointthat was alluded to, what would a recovery look like forthe CLOs? I keep hearing forecasts predicting somewherein the range of $8 billion to $10 billion of issuance thisyear, which may be encouraging but is still just a drop inthe bucket compared to the $400-plus billion that drovethe M&A market in 2007. I’m going to guess that wewon’t hit those levels for quite a while, if ever, so whatwould a recovery look like?Russell: That first $10 billion of issuance is probablybeing dedicated to old warehouses being cleared out.But there are some banks that are starting to warehouseagain, which gets the ball moving.There is a growing demand. We saw one CLO getformed, although one institution bought the wholedeal, so it is hard to say that it reflects the broader market.The ratings agencies have tweaked the model, soyou may start to see some lower leveraged CLOs startto take shape. The data is also starting to show the benefitsof middle market loans, both from a pricing perspectiveas well as from a risk perspective. I don’t thinkit happens this year, but in 2011 and 2012, you’ll startto see CLOs coming back.Cozzi: Right now, it’s not clear that you can get enoughleverage relative to the cost of the equity that someonewould put into a CLO to make it attractive yet.You’ve got all this liquidity being poured into biggerdeals, which is working its way down, so that’s pressuringpricing. At some point, though, the pricing willstabilize. I don’t know if it’s going to happen this year,or at some point in 2011 or 2012. We could see it40 MERGERS & ACQUISITIONS May 2010

when people start to tackle the refinancing cliff. Wheneverpricing moves up, though, that’s when I thinkyou’ll see the CLO market start to re-emerge.Borow: It’s worth noting that you didn’t see a bigcrater in the CLOs because they didn’t have to markto market. Because of that, they were able to survivewithin their covenants.Another thing is that a lot of them are still in theirinvestment periods. Once that lapses, the question iswhether or not that drives new issuance. But the economicswill still have to make sense because the underlyingcapital needed to finance the liability side ofthe balance sheet is still relatively high and the returnsdon’t quite work. With that said, I’m convinced WallStreet will find a way; they always seem to.Cordes: If you go back to ‘06 or ‘07 issuance, muchof it supported a part of the market that I don’t believewill come back anywhere near where it was before.Lower middle-market CLO issuance, supporting commercialfinance or specialty finance companies wereoperating in a very small part of the market.There were probably some lessons learned on thecredit side involving mistakes that I don’t think willbe repeated. You can look at the issuance from ‘06 and‘07 and carve out the small-market CLOs and some ofthe weaker credit classes, such as the non-rated baskets,and weak single-B baskets. Those aren’t likely toreturn to where they were during the bubble. Issuance“ Not every lenderwants to workwith everysponsor today.John CozziManaging DirectorAEA Investors”

Roundtable“We’ve learnedwho behaveswell in difficultsituations.Christopher CrosbyManaging DirectorNautic Partners”will come back, but it’s going to be supporting moreof a double-B type of credit profile.Crosby: We’ve all learned some lessons in the toughdeals throughout this cycle. From the sponsor’s perspective,we’ve learned who behaves well in difficultsituations and who’s either not experienced enough orflexible enough to be supportive.As an example, the regional banks don’t have asmuch experience or knowledge around sponsor-backedcompanies or the nature of a high leverage environmentand how it affects those businesses. In some casesthat meant the regional banks weren’t the strongestpartners to have in a troubled situation.The CLOs maybe have a better understanding ofthe market, but had some restrictions structurally onwhat they could and couldn’t do in certain situations.It’s the mid-market finance companies who are inthe market and will always be in the market, who takemore of a relationship point of view. For the most part,these groups were the most supportive and most constructivethrough some difficult stretches and that won’tbe forgotten.We’ll always look for the best pricing and best structure,but we’re not looking to push the capital structurethat aggressively. Because of that, we will look for therelationships that served us well in this environment.Mergers & Acquisitions: We haven’t really touched on thebusiness development companies, which had such a largepresence in the middle market but have gone through afairly significant dislocation.Russell: Some of the the large-cap names struggledwhen they started chasing growth and encountered amismatch of assets and liabilities. The ones that havedone better are the groups that concentrated more exclusivelyon debt. But the BDC model is sustainable andwe’ve already seen a few new ones arrive. There are alsoa couple of others that have filed for BDC status. Theyhave less leverage now, so I’m not sure they will comeback down into the senior portion of the market. Thenew BDCs really need a return of at least the low doubledigits, ranging from 13% to 15 percent. If you’reon a one-to-one leverage basis, you won’t get that inmiddle-market senior loans.There’s a lot of things you can do under the BDCstructure. Some of them have set up SBIC funds, somehave traditional credit funds. For the most part you’llsee them provide mezzanine or unitranche investmentswith limited equity components, but it balances moretoward the debt side of the world. The key is that they’refunded with permanent equity and that’s a big, bigpositive when you consider the sources of capital.Mergers & Acquisitions: Another group we haven’t reallytouched on is the hedge funds. Have they started to becomeactive again in this market?Russell: They seem to do the deals we’re not willing to.They still serve a very good role in providing capital forthe type of transactions that traditional senior lendersaren’t going to back. But they’ve lost that leverage too, sothey need to chase the higher yield type of deals, whetherit’s distressed financings, unitranche or junior capital.Cordes: I would bump hedge funds in with other seniordebt funds, in terms of where their capital is comingfrom, but their cost of capital is too high. And Ihaven’t seen a willingness yet for hedge funds to stretch,from a credit perspective, to make up for that highercost of capital. That was when they started to penetratethe market; when they came out with the unitranchestructures. That’s how they got issuers to accepttheir higher cost of capital, because they did more seniordebt or stretched deeper into the structure. Thathelped issuers get over the concern of partnering witha one-stop shop.Borow: They’re basically yield driven investors, so they’regoing to allocate their assets where they can to get thehighest yield. That’s what drove the tremendous amountof activity in the secondary market last year. Some hedgefunds out there used to have debt teams in place, andyou saw entire departments leave last year because they42 MERGERS & ACQUISITIONS May 2010

were just allocating their assets toward the highest yield.Mergers & Acquisitions: Switching gears a bit, since wehave so many PE groups here, I’d be curious to hear how dealstructures have changed. Is it safe to say that a 40% or 50%equity component is the new 30 percent?Borow: Kind of like flat is the new up?Cozzi: There are two dynamics at work. One is thatthe lenders have contracted. Sale prices also contracted,but not as much. So you can buy companies atlower prices, but you have to put in more equity tofund the deal. I think you’re starting to see that shift,but the question that intrigues sponsors is: when willleverage expand?It’s less about lenders coming to us and saying,‘We’ll provide you the debt, but you have to write a 40%or 50% equity check.’ It’s more about finding the leverageavailable and determining your return on equity.In the middle market, it’s something that sponsors havemore likely backed into. In the larger market, the lendersmay have more rigid rules, where they may provide“X” times leverage, but the sponsor has to contribute33% of the purchase price in equity.Winterer: Another phenomenon is that there is still alot of equity out there. Whether you’re talking aboutthe mega funds or even the middle-market funds, thereis a lot of equity that needs to be put to work.Sponsors are generally willing to over-equitize businesseswhen they find a good deal. It’s an interactiveprocess, in terms of figuring out what market leverageis and how these businesses are capitalized.Cordes: I don’t think it’s that arbitrary, though. Ofcourse, whether the equity component is 30% or 40%may be a function of not necessarily the lenders, butthe aggressiveness of the valuations, in which case theequity has to make up the difference.With that said, I still think we saw a significant increasein the equity cap purely out of concern fromthe lenders that there needs to be a significant cushionin terms of a perceived value of a particular business.This was driven by the uncertainty in the economy.Each lender is different, but I think there was more ofa macro change that is starting to shift back as peoplebecome more comfortable with a smaller equity cushion.This is a result of the market’s increasing confidencethat we’ve already hit the bottom.Cozzi: In all fairness, I’ve never really understood that.I don’t get why the amount of equity you’re putting inreally matters whether or not the debt providers arelending at 4x, 5x, or six times. It’s not going to affecttheir repayment. I get that they want to see some commitment,but I just never really understood the logicbehind it.Cordes: I think it’s purely a belief from the credit sidethat you are smart enough to value the company andthey’re trying to figure out the relative financing theyshould provide. I just don’t think they buy into theclaim anymore that you’re getting a company on thecheap. That used to be the argument for why you couldput 20% in — if they lend at 4x, and the sponsor canbuy it for 5.5x, they should be comfortable. That wasthe thinking.But there has been a line drawn in the sand by thelenders that they need more cushion. What you saw wasevery capital provider or regulatory agency looking atloan to value, which drives creditor’s decisions. Leverageis a function of value and what you pay is the value ofthe company, whether you think it’s a good deal or not.Borow: I totally agree: it’s loan to value. People arevery, very focused on that. Maybe it’s because we’re inthe smaller end of the market, but I have yet to get aterm sheet that doesn’t have a minimum equity requirementin it. Now, though, people believe we’ve hitthe bottom so they’re willing to accept less of an equitycushion, if you will, because the perspective is that“ It only takesone competitorto keepyou honest.Devon RussellSenior Managing DirectorMadison Capital Funding”May 2010 MERGERS & ACQUISITIONS 43

Roundtable“ You have towonder if theFederal Reserveis going to wantdeposit moneyinvesting inleveraged loans.William WintererManaging PartnerParthenon Capital”we’re on our way up.Last year, two things drove the higher equity components.There was the loan-to-value equation, plusthe practical reality that if you wanted to buy the companyyou had to provide more equity. What I’m hearingpeople say now is that the equity contributionshould be in the 35% to 40% range.Mergers & Acquisitions: Is everyone more cognizant ofthe capital structure today? For instance, do sellers, ifthey’re staying on with the business, want to see a largerequity slug as well?Crosby: With respect to entrepreneurs and family owners,I think there’s a natural tension for them. Theywant certainty of close and they want the best price, butif they’re going to be running the business post close,the want lower leverage too.When you’re sitting down with those family ownersin a process, there can be a debate over that tension.In general, I would say, price and certainty winout and sellers will accept additional leverage withoutreally a full understanding of the perils they may face.Cordes: There’s a structure for that, it’s called a PIKnote; a 5% PIK note.Russell: From a lender’s perspective, when we start offon a deal, the first thing we do is evaluate the company,its story, the clash flows, and every aspect of thebusiness. The last thing we focus on — and it’s morea product of the underwriting work — is the equity percentage.The equity percentage, the way we view it anyway,is that we want there to be some value, at least perceivedby the sponsor, which means they’re payingmore than the debt. But in general, it’s much more ofa fundamental credit analysis and the percentages aremore a function of where we think the debt shouldstop, based on a company’s ability to repay the loanunder different scenarios.We’ve been fortunate in that the valuations havebeen slower to fall than the debt, so the cushions haverisen. For us, it’s really more of a fundamental creditdrivenanalysis than a product of a hard and fast rule,although there are lenders who have to follow thosehard and fast rules.Mergers & Acquisitions: When sponsors are lining up adeal today and for whatever reason they’re contributingmore equity than say three years ago, is there a belief thatthey can just recap it when the markets improve and takea dividend out to readjust the leverage at a later date?Winterer: We definitely look at refinancing risks,particularly in capital-intensive businesses. Whatwe’ve gone through over the past two years hasmade us much more conservative when makingassumptions about that.Cozzi: We’re probably 180 degrees the oppositeway. We’ll look at the free cash flow and try to determinewhether we can get a return off of that,assuming very mediocre growth. If the math works,then everything — in terms of what you do operationally,acquisitions, refinancings — it’s all upside.With smaller funds, a dividend recap isn’t reallya viable concept. You never want to put thatmuch leverage back on a smaller business.Borow: When we make our investment decisions,we’re much more focused on whether we can growthe business, as opposed to financial engineering.Mergers & Acquisitions: It seems like we have seen areturn of dividend recaps, though.Russell: We have. I’d say that they are already at a levelnow that is on pace with the ‘04/’05 period. Therehas been about $10 billion to date and if you annualizethat, you’re pretty close.Cordes: These are pretty disciplined recaps though,versus ‘04. I haven’t analyzed the data, but my guess isthat if you look at the leverage for those vintage ‘04 or44 MERGERS & ACQUISITIONS May 2010

‘05 dividend recaps, you’re going to see a lot more debtbeing placed on those businesses than you’re seeingnow. Generally, most cases involve over-equitized andunder-levered companies relative to the market, soyou’re seeing sponsors installing a more efficient structure.It’s not so much driven by the dividend as it is byre-pricing the debt and extending the maturities.Russell: Which is what lenders want. They’relooking for that increase in pricing and it’s confinedto the really good companies. And I wouldagree, the leverage level on these are still lowerthan any new LBO. It’s very rational.Crosby: I put recaps in the same category asmultiple arbitrage. On the investment side, ifyou’re increasing margins, generating cash flowand growing the business, good things will happen.You’ll have an opportunity for recaps, butit’s not something anybody would model. Likemultiple expansion, it’s so dependent on thecapital markets that you can’t make assumptionsgoing in.Mergers & Acquisitions: Let me ask, in general,are you seeing significant changes to terms?Winterer: We’ve seen such a shift in the market over thelast six months that right now we’re seeing pricingcome down pretty substantially for quality deals. Therehas been a flight to quality by middle-market lenders,so they won’t stretch for that extra yield. They want tomake sure they get their principal back in an orderlymanner. It’s been encouraging from our perspective.There’s still a lot of focus on structure and the qualityof the asset, but it’s more balanced.Cordes: We’ve set our expectations so low. We feel likecheap money right now is eight percent.Crosby: To go back to one of Liz’s original comments,the market is still a bit binary. The good companiesthat represent a sound credit can strike the balance thatBill was referring to. But given the supply and demandin the marketplace, there’s a good chance that they’reover-equitized, which just augments the credit qualityand allows lenders to be a little more aggressive relativeto where they were 12 or even six months ago.Cordes: I personally think this is a pretty shallow recoveryfor the debt markets. If M&A activity picks up,you’re going to see some of this reverse pretty quickly.Right now, there are so few deals out there that thelenders with capital are competing with each other tostay active.Devon made the point earlier that it only takes onecompetitor to make a lender honest. But as you approachfinancings of $100 million to $120 million insize, where you are relying on four to six lenders tocome through, I’m a little more bearish. When M&Aactivity starts to grow, executions will become morespotty and pricing will start to climb.Cozzi: That’s a great point. It’s supply and demand.There’s just a lot of liquidity pouring into the marketright now, and that can turn in the next six months.Mergers & Acquisitions: I realize covenant-lite structuresnever really hit the middle market to the extent theydid in larger deals. Still, in hindsight, these deals held upa lot better than anyone expected going into the downturn.Is there something to be said for setting looser terms?Russell: In the middle market, covenant lite mightmean two covenants instead of three. In the large market,you have high yield, which is an incurrence-testmarket. Those investors aren’t really accustomed tomaintenance covenants. Plus, you have buy-and-holdinvestors in this space.If there’s a migration, I think we’ll potentially seea push on amortization. Instead of 5% or 10% in yearone, it will be interesting to see how quickly it movesdown to 2% or even one percent. There are definitelycompetitive pressures to get it back to one percent.Generally, you’ll see the marginal term here or there“ There hascertainly beenan effort by thelenders to pushback on terms.Gary ZussmanPrincipalGoldberg Kohn”May 2010 MERGERS & ACQUISITIONS 45

Roundtableget pushed from time to time, but pricing is always the first to go andthat’s definitely gone. The middle market, though, is kind of like themezz space in that it’s a stickier market.Cozzi: It’s usually the more subtle changes. For instance, how aggressivelydo your projections look going forward and do you tie yourcovenants to that, versus perhaps a more conservative approach. Also,how do you treat acquisitions and a company’s relative freedom to pursuethose.It’s the little things, and right now, we’re finding that people arebeing more accommodating again. It’s nothing crazy, but I wouldsay it’s more balanced.Winterer: For us, as Devon said, the amortization component is a bigone. We invest in growth businesses, so they may de-lever as a multipleof the Ebitda, but they don’t necessarily pay down debt. To the extentwe can get lenders to push back on amortization, that would be big.As far as covenants go, though, we’ve always had to deal withthem, and they will always be there. If you blow through one, you sitdown and talk to your lender and hopefully you can work through it.Russell: Missing a covenant isn’t the end of the world. It’s usuallyjust a few tweaks here or there.Cozzi: For all of us, I think it goes back to the design of the deal andwho you’re willing to have in your bank group.Mergers & Acquisitions: Gary, what have you seen as it relates to thelegal dealings between sponsors and lenders? In the large market, in thewake of Lehman’s collapse, you had lenders and sponsors suing each otherover broken commitments and finger pointing over all sorts of differentissues. Have there been any significant changes on the legal side? Forinstance, is there a clearer definition of what constitutes a MAC or havecommitment letters been tightened up?Zussman: I think some of the higher profile cases were informativeto lenders. In the Clear Channel deal, for instance, the lenders issueda commitment in May of ‘07 with a term that went out to Julyof ‘08, with no market flex or syndication out. I think the estimatefor the amount that the banks would have lost had they been forcedto go through with the original deal was in the range of $2.5 billionon a mark-to-market basis.So in the wake of that, there has been an effort by the lenders topush back on terms. They certainly want to keep market flex languagein the documents, although the syndication-out provisions are goingto be something that is negotiated on a deal-by-deal basis. It’ssomething that is less of an issue in the middle market, but it’s somethingthat is a concern on the bigger deals, since the market canturn very quickly.With respect to the MAC, I’ve seen a move toward adopting theseller’s MAC agreement as opposed to the lender maintaining theirown definition of what constitutes a material adverse change. Overthe last couple of years, there has been an understanding forged betweenthe lenders, buyers and sellers that they’re all looking at the samedeal, so it doesn’t make a lot of sense to have varying MAC clauses.I think the issue that will continue to pop up is the syndicationout and whether that is a risk that the seller should be taking on ora risk that only the lender assumes. It depends on the deal, but in myview the seller has to assume that risk.Russell: What worries me more is how long you extend the commitmentout. The shallowness of the recovery is still a consideration.If you have visibility and you can underwrite to that, you can extendthe commitments out to 45 days. That’s the market today. But if youstart extending it to 60 days, then it can get really uncomfortable. That’swhat you saw in the fall of ‘08. The markets actually came back fora little bit and then all of a sudden just collapsed.We’re comfortable providing true underwriting in situationswhere we can’t syndicate a deal. But we’re not underwriting $1 billion.We’re underwriting anywhere from $50 million to $200 million,so it wouldn’t be catastrophic. Still, there is a lot more work aroundit and you don’t do it with a blind eye, assuming that the world is nevergoing to change.Mergers & Acquisitions: What about market flex language? Is it fairto say that’s looser?Borow: It’s unusual on a sub $10 million Ebitda deal to get an underwriting.We normally club, but recently we received an offer to underwritebecause the incumbent was going to roll with the new deal.For the most part, it’s not an issue and came with full flex.Cozzi: There is a natural desire to box in the flexibility, but you alsorealize that handcuffing your lender too much can work against you.Crosby: There is also more of a mutual understanding between advisors,sellers and buyers. Two years ago, advisors were demanding commitmentsand trying to create certainty through all of the structuralways they could find. Today, people can agree on how difficult themarket is and we can hide behind that a little bit.In cases where you’re really trying to stretch the capital structure,that is where there might be more unease around certainty. In mostcases, you’re dealing with achievable leverage, involving one to threebanks, so advisors and sellers can get comfortable.Cordes: This will be a source of tension as we move deeper into theyear, though. As advisors start to push processes for the sellers, they’regoing to want the buyers to take the financing risks off of the table.If we’re dealing with smaller clubs, we can manage that in betweenthe signing of an LOI and the purchase and sale agreement,but that’s where the conversations will step up, and sellers will belooking at whether we buy insurance; whether we push a lender tounderwrite and provide some boxed flex, so we will be in position tosimultaneously eliminate financing as a condition.46 MERGERS & ACQUISITIONS May 2010

It’s still not in the market today but clearly advisors are watchingthe fact that these are good credits, good companies and translatinginto very strong processes. It’s just one thing they can do to drive adifferentiated process.Crosby: It will be interesting to see whether that’s driven by advisorsor sponsors. Because as sponsors are trying to differentiate themselves,that’s a tool you can bring out, but only if you can find the rightlender to support you in that regard.Russell: We’ve underwritten, since September, six deals. These are firmunderwritings. Sometimes it’s a back stop to a club, but the borrowersare willing to pay the premium. For a while, it wasn’t worth thepremium to underwrite because the flex was so wide for people thateveryone just assumed it wouldn’t happen.For the flex today, it’s company specific, but assuming it’s a rocksolidcredit, it’s guaranteeing funds at close.There are deals done at flex where we are going to allow for structuresto change. In the larger market, there’s more of an extreme,where guys are underwriting a credit and saying, ‘We’ll get you $2 billionof debt. It’s going to come in the form of senior, unsecured debtand public debt, but we’re going to get it for you.’In our world, though, it’s really not too different from ‘05, where it’sabout guaranteed funds. There is some pricing movement, and the abilityto increase pricing, but in general the terms are relatively locked in.Again, these are for the good credits, so you know what the downside is.Cordes: It probably depends on the amount you’re underwriting, too.Russell: Absolutely. It is a barbell. On the smaller deals, you’ll get prettygood pricing and good underwriting terms. In the large loans,where liquidity sells, those guys are going to get good terms. In themiddle, where it’s not quite as liquid and it’s outside the coverage ofthe traditional middle-market lenders, I think that’s where you mightstruggle the most.Mergers & Acquisitions: Earlier on, we alluded to the advisors andtheir roles in the market. In their quest for certainty, will we see stapledfinancing start to re-emerge?Cordes: I think ‘paper clip’ is the term people are using today. It’snot a true staple, but lenders are clearly trying to position themselves— when they know a credit — to get involved in the process throughthe advisors. They try to get out ahead of it, so they’re positioned toparticipate. The advisors will indicate terms that are available, but it’snot a true commitment or a true staple.Cozzi: Not every lender wants to work with every sponsor today. It’sunsaid, but assuming the sponsor has a good track record, the lenderwill be happy to work with them.Winterer: It will be interesting to see what happens when you havemass selling on the part of private equity owners. We haven’t startedto see it yet, but in the next year you’re going to see a lot of sponsorssell their portfolio companies to other sponsors and it will be interestingto see how those incumbent lenders react. They could just staywith the credit because they know it and it makes sense.Mergers & Acquisitions: Is that as easy as it sounds? It seems like therehas been so much secondary activity and you have so many different motivationsamong the various lender groups that it wouldn’t necessarily bethe smoothest process.Russell: Lenders are motivated to keep the credit if they’re already familiarwith it, assuming the new owner is acceptable.At the end of the day — and we’re involved with a situation likethis right now — it’s a ‘change of control,’ and as a lender, you can actuallyget dragged along. In the larger middle market, if we’re just a smallpiece, we can either keep it at the current pricing and current maturityor we can go along with everyone else and extend the maturity andget the better price. But it’s a 51% vote for the new owner.It’s not going to work in every case, but it creates an interesting dynamicfor these sponsor-to-sponsor deals.Cordes: It’s an option, but the reality is that a lot of these deals havelenders who are no longer in business or have no capital available. Inpractice you’re going to go to the people who are the strongest, wherethere may be an existing relationship.Zussman: I’ve actually had a couple of deals recently where the incumbentlender stayed on following the change of control. Therecertainly are some efficiencies with that and the documentation ismuch less involved.But these were not big, syndicated groups, where you have a disparatelender base.Borow: And sellers encourage it. I know of a few situations right nowwhere the sellers want the buyer to stay with the incumbents becauseof the speed.It’s actually having a chilling impact on the other lenders youwould go to, who may not want to spend the time on that particularcredit. There was one that we were looking at and people prettymuch dismissed it once the incumbent made it clear that they wantedto stay in and it was a two-handed senior deal.We have a general view of where the market should be anyway,so I think it has more of an impact on the lenders than anyone.Mergers & Acquisitions: We touched on the regulatory environmentearly on when we were discussing the regional banks, but I’d like to getsome more thoughts on it. I realize there’s still a lot of moving pieces regardingthe legislation, but what kind of impact will this have on thebroader debt markets?ROUNDTABLE continued on page 71May 2010 MERGERS & ACQUISITIONS 47

Earnout ImplicationsImplied obligations are making buyers second guessperformance based dealsBy Ken MacFadyenEarnoutsultimatelycome downto control.It’s generally understood that in a perfect world,there would be no need for buyers and sellers tostructure transactions with an earnout provision.In today’s far from ideal M&A market, however,dealmakers are more frequently calling on theseprovisions to help bridge the gap between buyer andseller expectations. While both sides probably feel prettygood about the earnout if it helped clear a hurdle otherwisepreventing a close, it may not be long beforethe earnout becomes a source of dispute.The historic tension between buyers and sellers relyingon earnout provisions relates back to the role ofthe acquirer once the deal is completed and their responsibilityregarding the performance of the assets postclose. If the benchmarks aren’t met, depriving sellers ofexpected payouts, the sellers will argue that the buyer“didn’t do enough to ensure the earnout was met. Everyfew years a new case pops up that provides a precedentfor earnout structures.In 2007, for instance, AmerisourceBergen Corp.was on the losing end of a decision in which the companywas blamed for a missed earnout that the courtsruled was owed Bridge Medical’s former shareholders.AmerisourceBergen acquired Bridge in 2002 througha $27 million deal that included the possibility of another$55 million payout if Bridge hit certain bench-”marks. Bridge failed to reach the specified milestones,but the court ruled that AmerisourceBergen had failedto actively “promote” and “market” Bridge’s currentline of products and services.While there may be some debate around the definitionof active promotion, the contract did stipulatethat the buyer had to make an effort on behalf of thetarget. Two new cases, however, has lawyers taking a secondlook at earnout provisions because the courts ruledthat such a duty can be implied.When PerkinElmer Inc. acquired Sonoran Scannersin 2001, the buyer paid $3.5 million, and includedan earnout that could double the value of the dealshould certain performance milestones be met. Thebuyer even hired the company’s founder, and includedan incentive laden contract that outlined as muchas $6.6 million in bonuses if the company surpassedother specified targets. Sonoran, which manufacturedcomputer-to-plate printers, managed to sell only a singleunit under its new owner, and three years after thedeal, the business was shuttered.Sonoran’s founder, in a subsequent lawsuit, claimedthat PerkinElmer had an “implied obligation to exertreasonable efforts to develop and promote” the acquiredassets. Since a provision obligating the buyerto put forth reasonable efforts was not included in theoriginal purchase and sale agreement, Sonoran successfullyargued that such an obligation is implied.PerkinElmer was granted summary judgment by aMassachusetts district court overseeing the case, butthe First Circuit Court of Appeals overturned the decision,citing an earlier precedent set by the SupremeCourt of Massachusetts involving intellectual propertyand licensing agreements.The ruling, according to David Denious, a partnerat law firm Dechert LLP, has “the M&A bar buzzing,”especially given the popularity of earnouts recently.Denious says the ruling could make it more difficultfor buyers and sellers to negotiate around anearnout, since acquirers are going to be more carefulabout including disclaimers that make them immuneto similar claims.“Earnouts ultimately come down to control. Theseller is linking their payout to a business in whichthey no longer have a voice,” Denious says, addingthat now buyers are being forced to document in theagreement that not only will the sellers not have anycontrol, “but now [the buyers] don’t even have to try.”The Sonoran case is not the only example. Accordingto a recent client note from law firm Debevoise &Plimpton, a similar ruling unfolded in Ohio. After NAManagement Corp. acquired a subsidiary of Eggert48 MERGERS & ACQUISITIONS May 2010

“It can save the deal.”Agency, the seller sued the acquirer on claims that job cuts and theelimination of a key office prevented the target business from reachingspecified milestones. Moreover, the seller also claimed that the buyerconverted the clients to its own technology platform. Again, therewere no provisions dictating the buyer’s obligations,yet the US District Court for theSouthern District of Ohio ruled that theywere implied.Deal pros, however, don’t necessarily believe that the rulings willdissuade buyers and sellers from using earnouts. Deborah Hong, apartner in the business practice group of law firm Stradley, Ronon,Stevens & Young, notes that she is currently working on two separatedeals that incorporate earnouts and that, by and large, she is stillseeing more and more instances in which buyers and sellers use theprovisions to close a gap. Still, she cites that generally, these clausesare “one of the sensitive areas of negotiations.”Generally, she says, it is easier to execute when buyers are dealingwith a set of assets that will remain independent post close. Thiseliminates the potential for dispute around attribution and where,specifically, revenue was derived. Moreover, she adds that it helps ifexisting management stays on with the asset, which precludes someof the fights that tend to erupt over control.Another area that can lead to disputes relate back to the accountingmethods of each party. She says that precision is important inthis particular area so both sides are on the same page as it relates tothe definition of Ebitda. This issue also came up in the Amerisource-Bergen/Bridge Medical case. Hong says that she will not only specifyaccounting metrics, but also develop formulasand provide examples to eliminateany confusion over the math.A new trend Hong is seeing is the use ofcall options, which can limit buyer risk since it allows them to buyoutthe earnout ahead of schedule if it looks like the target is goingto surge past the set milestones. This can make the accounting easiertoo, especially if the earnout is extended out multiple years.From the sellers’ perspective, more earnouts are being negotiatedwith change in control accelerations. If sellers are already worriedabout control when they choose the acquirer, it’s only natural that ifthe buyer gets sold or decides to unload the asset, they’ll seek protection.Hong adds that seller counsel is increasingly thinking aboutbuyers’ credit worthiness, and in some cases, attempting to force buyersto put money aside in escrow.Meanwhile, as the lawyers may fret about the details of anearnout, buyers and sellers will continue to turn to the provisionsto help bail them out of an otherwise unbreakable impasse. To a lotEARNOUT continued on page 70

ProfileIn Search of the NextGreat TurnaroundFormer Delphi CEO Steve Miller eschewed retirement,joining MidOcean Partners to continue his pursuit ofreclamation projectsBy Kelly Holman“Troubled companiesare typicallyin denialand can’tunderstandwhy they’rein trouble.”Robert “Steve” Miller has been associatedwith workouts of some of Detroit’sbiggest corporate mishaps — he was LeeIacocca’s point man at Chrysler Corp. inthe 1980s and ran Delphi Corp. duringits bankruptcy. Now he is shifting gears and focusingon small businesses owned by a New York private equityfirm, including a pizza chain, an umbrella makerand a manufacturer of binoculars.In December, Miller was appointed as the chairmanof the seven-year-old MidOcean Partners, whichinvests in companies with enterprise values of up to$500 million. His primary tasks are to fine-tune itsportfolio companies and help select new investments.Across the industry, sponsor firms are reexaminingthe efficiency of their portfolio businesses inresponse to sluggish economic growth, tight creditconditions and the heavy debt burdens at manyof the businesses.A study published by Moody’s Investors Servicesaid that a lot of firms owned by private equityhave turned to distressed debt exchanges oramendments of their credit terms. The ratingsagency also found that nearly half of last year’s corporatebankruptcies came from sponsor-ownedbusinesses.“Coming out of this recession, companies areoverlevered,” Miller, 68, told Mergers & Acquisitionsin March at MidOcean’s Manhattan offices.“We still have enormous opportunities in rebuildingthe balance sheets of companies that have hada hard couple of years.”Miller is visiting MidOcean’s portfolio companies,which are located in places like Overland, Kan., LongRobert “Steve” MillerIsland, Cincinnati, England and Puerto Rico. “I’m goingto be making a round trip visiting all of our operatingentities and, based on my experience, look athow we might do [things] better or differently.”MidOcean has a $1.3 billion fund, $780 millionof which remains unspent, leaving the firm in a goodposition to buy into ailing companies.“There are a lot of good companies burdened withbad balance sheets. If that means buying the companyfrom its creditors or buying up its debt as a way totake ownership, I think we’d look at all the means inwhich we can create value for our investors,” said TedVirtue, MidOcean’s chief executive.Miller says many companies and their owners wouldwelcome another investor to avoid a court restructuring— a process the workout pro has likened to kidsfighting over an ice cream cone as it melts.“If you can keep it out of court by doing a restruc-50 MERGERS & ACQUISITIONS May 2010

turing, then you avoid the expense of alengthy bankruptcy process,” he said. “Privateequity can act nimbly and bring equity,which is what these companies typicallyneed.”According toMiller, in additionto managing adownturn in demandfor theirproducts and figuringout how to paydown debt, troubledcompanies have a common denominator:ineffective management. “They’re typicallyin denial and can’t understand whythey’re in trouble.”He also says that employees are quick topick up on this lack of direction, and thissaps morale. “Every business succeeds or failson whether people are excited to come towork in the morning. You’ve got to get a notionof ‘We can do this.’”The issues of bad management andmorale crop up in Miller’s 2008 memoir,“The Turnaround Kid: What I Learned RescuingAmerica’s Most Troubled Companies.”In that book, he wrote that the best gaugeof a company’s health is employee morale,and that one way he has measured it is by sittingin the company’s cafeteria to listen togripes and ideas that may not make it up tosenior managers.Miller also wrote that each corporate crisisis unique, though one thing they have incommon is hubris that blinds the seniormanagers to changes in the marketplace; thebook cites Aetna’s Richard Huber and MorrisonKnudsen Corp.’s William J. Agee asexamples.Virtue said, “When we visit a company,it helps to have someone who’s walked thefactory floor and looks at companies in a differentway than through financial models.”Miller “has worked with a number of companiesacross different industries, and he’s gota great approach in trying to drive value andsimplify complex situations.”With his new role at MidOcean, Millerreturns to a city where he got his taste of thefinancial services industry almost 20 yearsago.In 1992, he joined James WolfensohnInc., a New York investment bank foundedby a former World Bank president, as a seniorpartner. Although he spent only a yearat the boutique, Miller got a taste of one of“He can see the forest from the trees. But healso understands that you don’t want to runinto trees while looking at the forest.”the biggest real estate workouts before thelatest commercial property bust: the $20 billionrestructuring of developer Olympia &York.At MidOcean, Miller succeeded MarkAngelson, the former CEO of the printer RRDonnelley & Sons Co. Angelson, who chairedMidOcean from 2007 to 2009, will remain onits executive board. Other board members includeformer Time Warner Cable CEO JosephCollins and former Gov. George Pataki ofNew York.Even though Miller is closely associatedwith automaker workouts, MidOcean plansto stick to its knitting: business services, communications,mediaand industrial companies.“Steve has aunique skill set ofhaving worked in alot of corporate environmentsand alot of restructuring situations,” said RobertDel Genio, a principal at the New York restructuringfirm Conway Del Genio Gries& Co. “With the competition in private equityright now, the real opportunities are createdby working with management to improvethe operations of a business and providestrategic direction.”Over the last 42 years, Miller has builtcompanies and an extensive career, includ-May 2010 MERGERS & ACQUISITIONS 51

Profile“Private equitycan act nimblyand bringequity, which iswhat thesecompaniestypically need.”ing stints as a CEO, a chief financial officer and a boardmember. (He’s a director at American InternationalGroup Inc., Symantec Corp. and United Air LinesInc.)For a decade starting in the mid-1990s, he heldthe CEO posts at companies like Federal Mogul Corp.,Waste Management Inc. and Bethlehem Steel Corp. InJuly 2005, he joined Delphi, a Troy, Mich., maker ofauto parts, as its chairman and CEO and soon foundhimself in the middle of a contentious situation. Threemonths after he joined Delphi, which once was part ofGeneral Motors Corp., his company filed for bankruptcyprotection.Even if the economy and the credit markets hadbeen stable, Delphi would have been a challengingworkout, because of its unionized work force. The fastchangingconditions in the financing market madethings even tougher for Miller. “About the time wewould get a plan put together, the capital markets andautomotive market would’ve deteriorated to the pointwhere you needed to go back to ground zero.”For example, Miller said, Delphi received a $2 billioncommitment from David Tepper’s hedge fund,Appaloosa Management, but the deal unraveled as financingconditions deteriorated. “By the time we gotto the end of the Chapter 11 process to ‘OK, here’sthe closing. Show up with your money,’ things hadmoved so fast that they balked and didn’t show.”Delphi emerged from Chapter 11 protection inOctober, leaving Miller free to pursue his next endeavor.He contemplated doing nothing, he said, but hedecided to pursue private equity, as his friend JacquesNasser, the former Ford Motor Co. CEO, had done.Oddly enough, when Miller visited MidOcean’sPark Avenue office in December, he bumped into Nasser,who now works at JPMorgan Chase’s private-equityunit, One Equity Partners, in the lobby of the officetower where the firms are headquartered.Miller is perhaps best known for his turnaroundprowess in the automotive industry. In 1968, he joinedFord’s finance department “right after Mustang hadcome out, and it seemed liked a hot company.” In his11 years at the company, in addition to ramping uphis financing knowledge, he got hands-on experiencewith its products. One of the cars he drove was a redMercury Cougar convertible.More importantly, Miller gained international businessexperience by working in the company’s Australia,Mexico and Venezuela offices. He learned Spanish(with the help of a Berlitz course) during a two-year stintin Mexico City as a financial analysis manager. He recalledthat he picked up the language of business quickly,but little else. “During the [work] day, I could talkbusiness Spanish, but then on a Saturday, I’d go to aflower shop with my wife, and I’d have no clue as to howto start a question.”Miller left Ford in 1979, when Iacocca broughthim to Chrysler. The executive was soon leading negotiationswith 400 lenders in the Detroit automaker’sbailout. That work would earn Miller a place in thepantheon of restructuring professionals, and it addedsenior executive experience and titles to his resume.He spent 10 years as the company’s CFO and two yearsas its vice chairman.Working at Chrysler also gave Miller valuable skillsin crafting acquisitions, principally the purchase ofAmerican Motors Corp. from Renault in 1987. Duringnegotiations for that deal, he shuttled back andforth between Detroit and Paris.In 1982, Miller met Stephen Schwarzman, nowBlackstone Group’s CEO, who was an M&A bankerat Lehman Brothers at the time and handled the saleof Chrysler’s defense business to General DynamicsCorp.“Steve’s got great judgment, and he’s unflappable.He’s orderly, bright, reflective, balanced, and he cansee the forest from the trees. But he also understandsthat you don’t want to run into trees while looking atthe forest,” Schwarzman said. When asked aboutMiller’s take on unfocused managers who can be trippedup by their hubris, Schwarzman agrees: “All he’s sayingis that sometimes people aren’t objectively lookingat the problems they are looking at.”The two executives first met when “Chrysler hada whole series of problems, and Steve was the treasurerwho handled most of the restructuring,” Schwarzmanrecalled. “I worked a lot with Steve on the restructuring,including testifying in Congress.”The experience at Chrysler and his backgroundworking with distressed companies gives Miller a uniqueperspective on last year’s government bailout of automanufacturers. In fact, the workout specialist warnedthat how the restructuring of Chrysler and GeneralMotors were handled likely will have ramifications forcompanies looking to raise money in the coming years.“You had the secured lenders at Chrysler being toldby the president of the United States to get out of theway, and the other stakeholders came out on top,” hesaid. “That might’ve been good politics and economicsin that situation, but the next time that a troubledindustrial company wants to raise secured financing,they will not be able to make the same promise. Politicianstomorrow may decide that they do not want tohonor the security that you thought you had.”52 MERGERS & ACQUISITIONS May 2010

Guest ArticleThe End of the RoadIs there anywhere left for distressed stakeholdersto kick the can?By Geoffrey Frankel“Lenders areshowing agreater desireto monetizetheir position.”At a recent distressed investing conference,I overheard the following: “We don’t expectto see very many distressed investingopportunities for the next three to sixmonths, but after that, all bets are off.” Itwould be easy to dismiss this as the kind of exuberantprediction that one tends to hear in conversations betweenrestructuring professionals and distressed investors.There are signs, however, that these predictionsmay actually have merit and that the ‘can’ troubledcompany stakeholders have been kicking for the past 18months may have finally reached the end of the road.Since the onset of the US financial crisis in 2008 —and continuing through 2009 — the market for distressedM&A opportunities has been remarkably quiet.To be sure, many businesses were quickly shut-downand liquidated, wound-down in an orderly manner, orsold as a going concern at, or just slightly in excess of,liquidation value. The common thread found in mostof these situations was a liquidity crisis that could notbe resolved either with new capital, which, for all practicalpurposes, was non-existent,or by any of the existingstakeholders, who were eitherunwilling or unable to providethe requisite capital due totheir own liquidity issues. Theend result is that many troubledcompanies were forcedto liquidate or sell as their onlyalternative.High-profile examples areLinens ‘n Things and CircuitCity Stores. In almost anyother business environment,the stakeholders of these companiescould have been expectedto pursue either an outof court restructuring or aChapter 11 bankruptcy reorganization — including asale as a going concern. But, given the lack of availablecapital to solve their liquidity crises, they were insteadforced to liquidate their assets.The lack of distressed M&A activity has createdan interesting disconnect between the value of assets inbankruptcy cases and the value of assets for sale. (Seechart, below.)More often, over the past 18 months, stakeholdersof troubled companies have preferred instead to postponethe day of reckoning in the hope that an eventualimprovement in business valuations would producean outcome superior to a near-term sale. This has ledto a wave of balance sheet restructurings and other operationalturnaround strategies in lieu of exposing atroubled or under-performing business to the M&Amarkets. Throughout most of 2009, senior lenderswere willing to ‘amend and extend’ their existing loanagreements to avoid the recognition of substantial lossesfrom the sale of their borrower. And, given that theirclaims and interests were often out of the money, jun-Correlation between Default and Bankruptcy SalesSource: Capial IQ54 MERGERS & ACQUISITIONS May 2010

ior stakeholders have happily participated in the kickthe-canstrategy.Thus, Q4 2009, distressed M&A, at least for middle-marketbusinesses, remained in a deep freeze andthe principal cause for this was the lack of credit for middle-marketacquisitions. Moreover, borrowers have seentheir cost of borrowing increase, and despite improvementsfor large corporate borrowers, the middle-marketremained at, or near, highs not seen since 2002 or2003. By the end of 2009, it seemed that whateverconfidence had started to return to the debt markets forlarger companies, it had yet to translate in lower borrowingcosts or credit availability for the middle market.Of course, the cost and availability of credit fordistressed middle market transactions, obviously, wasunder significantly greater pressure.More recently, there is mounting evidence thatthese trends are reversing. Troubled companies andtheir stakeholders, who even three to four months agowould have avoided selling if at all possible, now appearto at least be open to an M&A solution if not favorit as the preferred alternative.The return of distressed M&A, if it indeed doestake hold, could be attributed to two paramount developments.First, and most significantly, liquidity is beginningto return to the middle market. Issuance ofleveraged loans, both in volume and number, has increasedincrementally each quarter since the lows ofQ4 2008. And while it remains challenging to find financingfor a distressed middle market situation, lendershave slowly begun to re-enter the market for these opportunities,too.Second, stabilization in the overall economy hasimproved the reliability of business forecasts and, as aresult, the ability of buyers to underwrite greater transactionvalues. Not surprisingly, therefore, middle-marketstakeholders have increasingly emerged from thesidelines into the M&A markets.With that said, laggingstakeholders of healthy companies, at least senior lenders(or, subordinated lenders, if they are the fulcrum security)are showing less inclination to continue kickingthe can down the road and a greater desire to monetizetheir position.All of this suggests that the hopeful comments atthe recent distressed investing conference may indeedKICK THE CAN continued on page 70“ A disconnectexists betweenthe value ofassets inbankruptcycases and thevalue of assetsfor sale.”

Guest ArticleFASB’s Fair Value UpdateNew disclosure requirements aim to providemore transparency in alternative investment funds’financial statementsBy Tom Del Core and John BarbagalloThe updateaims toincreasetransparencyfor entities thatare requiredto disclosefair-valuemeasurementsin theirfinancialstatements.Investors spoke and the Financial Accounting StandardsBoard listened. Just when financial statementpreparers in the alternative investment fundindustry were getting accustomed to the new requirementsfor fair-value disclosure, FASB expandedthose requirements by issuing Accounting StandardsUpdate (ASU) No. 2010-06: ImprovingDisclosures About Fair Value Measurements.While at first glance it may seem that the new andimproved disclosure requirements are excessive, thisupdate provides some very useful information that willbenefit investors and other users of the financial statements.This enhanced transparency will help to restore“investor confidence and could promote increased assetflows to the alternative investment space.The update was issued in January 2010 to providenew and improved disclosure requirements and to increasetransparency for entities that are required to disclosefair-value measurements in their financial statements.Generally Accepted Accounting Principals requiredisclosures designed to provide investors with informationregarding the extent to which fair value is usedto measure assets and liabilities, the methods and assumptionsused to measure fair value, and the effect offair-value measurement on earnings.GAAP also requires the use of a fair-value hierarchyfor inputs used in determining fair value as follows: (1)Level 1: valuations based on unadjusted quoted pricesin active markets for identical assets or liabilities; (2)Level 2: valuations based on quoted prices in marketsthat are not active or for which all significant inputsare observable, either directly or indirectly; and (3) Level3: valuations based on inputs that are unobservable”and significant to the overall fair value measurement.The update amends GAAP by requiring two newdisclosures: transfers in and out of Levels 1 and 2, andactivity in Level 3 fair-value measurements. Prior tothe issuance of the update, FASB Accounting StandardsCodification Topic 820: Fair Value Measurements,did not require reporting entities to disclosetransfers between Level 1 and Level 2 in the fair-valuehierarchy.The update will require reporting entities to notonly disclose significant transfers in and out of Levels1 and Level 2, but also the reason for the transfer. Significanttransfers into Levels 1 and 2 have to be disclosedseparately from transfers out of those levels. For investmentfunds, “significant transfers” will usually bemeasured against the fund’s net-asset value.Management should consistently follow its policyfor determining when transfers between levels are recognized.Funds should access the level designations ona quarterly basis and apply the policy of recognizingtransfers consistently, either at the beginning or endof a quarter. This will greatly improve the transparencyfor users of financial statements and allow them tounderstand movement between all levels within thefair-value hierarchy.The update also changes the presentation requirementscurrently effective under GAAP relating to thefair-value measurement reconciliation for significantunobservable inputs. This is commonly referred to inthe footnotes to the financial statements as the Level3 roll-forward table.Currently, a reporting entity is required to disclosea reconciliation of the beginning and ending balancesfor significant unobservable inputs. This is done bydisclosing net gains and losses for the period, purchases,sales, issuances, and settlements as one net number,and transfers in or out of Level 3 on a net basis.The update will require that the Level 3 activitybe shown on a gross basis. However, while the effectivedate of ASU 2010-06 is for reporting periods beginningafter Dec. 15, 2009, the gross-basis presentation requirementfor Level 3 activity will not be effective un-56 MERGERS & ACQUISITIONS May 2010

til fiscal years beginning after Dec. 15.FASB delayed the effective date for this disclosure to give entitiesthat require significant changes to their information systems adequatetime to comply with the new standard. As a practical matter,investment funds should begin to evaluate the impact of this newdisclosure requirement.The update also requiresa reporting entity to providefair-value measurement disclosuresfor each “class” of assetsand liabilities. Currently,reporting entities are only requiredto disclose information relating to “major categories.” Whilethe update does not specifically define the criteria of a class, it doesprovide guidance as to what the components of the class should entailbased on the nature and risks of the assets and liabilities.Although the new guidance calls for updated and enhanced disclosures,the good news for investment funds is that they are alreadydetermining various levels of disaggregation when preparing theircondensed schedule of investments (SOI) in the financial statements.Preparers of investment fund financial statements can save time andeffort by starting this process early and preparing the footnote disclosureshowing assets and liabilities by class in conjunction with the SOI.The update also clarifies the disclosure requirements relating toinputs and valuation techniques used to measure fair value. For fairvaluemeasurements using significant other observable inputs (Level2) and significant unobservable inputs (Level 3), a fund will nowbe required to disclose a more detailed description of the valuationtechniques used in determining fair value for each class of assets andliabilities. Funds will also be“A fund will now be required todisclose a more detailed descriptionof the valuation techniques.”required to disclose changesto valuation techniques andthe reason for such changes.The overall objective ofthe update is to provide increasedtransparency for the users of financial statements that requireassets and liabilities be measured at fair value. Fair value has been, andwill always be, a sensitive area to investors and other users of financialstatements.For many investment firms, the effort associated with compliancewith the update will be offset by increased industry asset flows associatedwith restored investor confidence, particularly among institutionalinvestors who typically rely on a greater level of disclosure.John Barbagallo and Tom Del Core are senior managers at Rothstein Kass,a national CPA and advisory services firm.

PeopleBankers MoveThe mid-market investment banks and lenders drove personnel activityin March and early AprilExecutives continued to swap spots among the investmentbanks, as Lincoln International, Houlihan Lokey, Harris Williamsand William Blair were among those to bring in new blood recently.PE groups, meanwhile, bolstered their operational strength, asGenstar Capital and Riverside each added advisors, with Genstaradding tech expertise and Riverside bringing in a McGraw Hill vetto focus on education.The debt markets also started to see rumblings of activity.Crystal Financial, for instance, launched a debt origination andunderwriting business, while LBC Credit Partners brought in a JP-Morgan vet to oversee new debt investments.Babson Capital Management—TheSpringfield, Mass.-based asset managerlaunched a new team in Sydney,Australia tosource mezzanine debt and private equityinvestment opportunities in the Asia Pacificregion.Michael Hermsen, who co-heads Babson’smezzanine and PE activity will spearheadthe new effort. Shane Forster and AdamWheeler were brought on board as managingdirectors, both arriving from AMP Capital Investors,where they oversaw roughly $AUD700million dedicated to Asia and Australia.Babson is committing eight people to thenew team, with four based in Sydney andthe balance based in Asia and the US. Thenew group will target mezzanine debt investmentsand equity securities in mid-marketcompanies residing primarily in Australia,New Zealand and developed countries inAsia, such as Japan, Singapore, South Korea,Taiwan and Hong Kong.Buccino & Associates—The Chicagobasedadvisory firm added Thomas McCabeto its practice.McCabe is a turnaround pro who beganhis career with Arthur Anderson & Co. Thenew senior VP and director with Buccino willwork with clients across a variety of industries.Bunker Hill Capital — The Boston-basedprivate equity firm tapped Robert Dreier toserve as a director of business development,a new position at the firm.Dreier most recently served as a managingdirector and co-head of the financialsponsors group at investment bank BB&TCapital Markets. Before that, he served inthe M&A group of RBC Capital Markets andat Tucker Anthony in a similar role.The Carlyle Group—The private equity firmnabbed former Morgan Stanley sales andtrading chief Michael ‘Mitch’ Petrick as itsfirst global head of credit alternatives andcapital markets.Petrick, who’s been named managingdirector and will join Carlyle’s operatingcommittee, will lead the firm’s leveraged finance,mezzanine and distressed teams.He will oversee a total of 57 investment professionalsand funds with $19 billion inassets.He was most recently managing directorand global head of institutional sales andtrading with Morgan Stanley, where heworked for 20 years.Centerview Partners—The private equityfirm added David M. Cohen to its ranks. Cohenwill join the private equity firm’s NewYork office as a partner.Cohen spent 13 years at JPMorganChase. He served as a managing directorand the global head of the industrials groupat JPMorgan Securities and also served asa co-head of the North America M&A groupat the bank. More recently, Cohen served asmanaging director of JPMorgan’s One EquityPartners, the bank’s PE shop.He also worked at Wasserstein & Perellaand as a management consultant for Bain& Co.Deloitte — The firm appointed Guy Langfordas the lead of its distressed asset anddebt practice.Langford was previously an accountingprincipal in Deloitte’s M&A Services practice.Based in New York, Langford will overseethe cross-disciplinary national practicethat over the past 12 months has grown tomore than 60 other professionals.Greenhill & Co.—The investment bank hiredfour managing directors from Credit Suisseto build its real estate placement advisorybusiness.The managing directors — Bill Thompson,Fredrik Elwing, Pamela Wright andWalter Stackler — were previously seniormembers of Credit Suisse’s real estate privatefund group. Thompson and Wright willcontinue to be based in San Francisco, while58 MERGERS & ACQUISITIONS May 2010

Stackler and Elwing will work out of Greenhill’sNew York and London offices, respectively.Greenhill’s new practice will focus onraising capital for real estate funds, joint venturesand recapitalizations, and will also advisereal estate fund investors looking to sellinterests in the secondary market.Greentech Capital Advisors—The advisornabbed Deutsche Bank private placementveteran Heather Smith to spearheadits efforts in the market.Smith joins the firm as a partner and thehead of private placements. She will be responsiblefor leading the structuring, marketing,and negotiation of private equity anddebt placements.She has about 14 years of experience inthe private placement industry, most recentlyat Deutsche, where she headed structuredprivate placements.Harris Williams & Co. — The mid-marketinvestment bank hired Douglas Yablonskiand Patrick McNulty as a managing directorand director, respectively. The pair arejoining the firm’s Richmond office.Yablonski previously served as a managingdirector in the global industries groupof Banc of America Securities, and also spenttime at Merrill Lynch. He began his careeras a lawyer at Skadden,Arps, Slate, Meagher& Flom LLP.McNulty, meanwhile, joins from PorticoCapital Securities, where he led the firm’sM&A group. He spent time at Deutsche Bankand UBS before joining Portico.Ward MooneyCrystal Financial —The Boston finance company launched a debt origination and underwriting business.Thenewly formed business, backed by SorosFund Management LLC, will make senior term loansof up to $150 million.Crystal Financial is headed by chief executiveWard Mooney, who joined the firm in 2005 afterstints at Bank of America, where he was the presidentof the firm’s retail finance group, and BackBay Capital, where he was the chief operating officer.The company’s Web site outlined a wide rangeof debt products that will be offered to clients, includingfirst-lien and second-lien loans, bridge financingand debtor-in-possession facilitiesHoulihan Lokey—The investment bankhired Robert Hyer Jr. as a managing directorin charge of its new financial technologybanking group. He joins from Greenhill & Co.,where he was a managing director.At Greenhill, Hyer advised Kohlberg KravisRoberts on its $27 billion acquisition of FirstData and Ceridian on its proxy defense and$5.2 billion sale to Thomas H. Lee Partners.He previously spent 19 years at Citigroup,where he founded the firm’s global electronicservices group.Bruce Urbanek, a financial technologyspecialist, also joined Houlihan Lokey as avice president on Hyer’s team. He previouslyworked for Goldman Sachs and Citigroup.Separately, Houlihan hired ChristopherCerimele as a director and head of the chemicalspractice in the firm’s industrials group.Prior to joining Houlihan Lokey, Cerimelespent more than seven years with LincolnInternational, where he founded the firm’schemicals practice and served as its globalco-head of chemicals and head of chemicalsfor North America.Genstar Capital — The mid-market PEshop named Steve Mankoff and David Wroeto its strategic advisory board. The appointmentsbolster the firm’s capabilities in techand software.Mankoff was previously a senior VP atSiebel Systems, overseeing its global andtechnical services division, while Wroe previouslyserved as chairman and CEO ofAgency Management Systems, targeting theinsurance sector.Hunter Wise Financial Group—The California-basedmiddle market investment bankadded Russell Gorman to its ranks as amanaging director.Gorman has experience as a director withMerrill Lynch’s high yield credit research teamand with Moody’s as a senior analyst andvice president. With Hunter Wise, Gormanwill work on energy and consumer productsevaluations for middle market deals.InfoSpace — The Nasdaq-listed searchprovider has recruited GCA Savvian Advisorpartner and managing director StephenHawthornthwaite to serve as the vice presidentof corporate development. In the newrole, Hawthornthwaite will be focused on“identifying and executing” acquisitions, accordingto a statement.The move represents a jump from WallStreet for Hawthornthwaite, who before GCASavvian, put in stints in the investment bankingteams of Jefferies Group and RobertsonMay 2010 MERGERS & ACQUISITIONS 59

PeopleStephens. He has primarily focused on technologyM&A, and at GCA was based in thefirm’s San Francisco office.Kohlberg Kravis Roberts—The PE shoppromoted four professionals in its asset managementdepartment to run the firm’s specialsituations and leveraged credit strategiesefforts.KKR appointed Jamie Weinstein andNathaniel Zilkha from within to run its assetmanagement global special situationsstrategy, which includes distressed debt,debtor-in-possession and rescue financing,as well as other structured investments.Erik Falk and Chris Sheldon were alsopromoted to run the firm’s asset managementleveraged credit strategy, comprisedof leveraged loans, high-yield bonds andstructured products, including collateralizedloan obligations.Lincoln International—The middle marketinvestment bank hired Eric Wijs as a managingdirector in charge of its new Amsterdamoffice. He will also oversee coverage ofthe Benelux zone (Belgium, the Netherlandsand Luxembourg).Wijs was previously a managing directorat Lazard, where he spent 11 years in the financialadvisory practice and opened thefirm’s Amsterdam office in 2004.Separately, Frederico Mennella wasnamed as a co-head of the mid-marketbank’s global chemicals practice. He joinedthe firm in 2006 to oversee the firm’s NewYork office.Prior to Lincoln, Mennella headed JP-Morgan Chase’s global chemicals M&A groupand before that spent time at Deutsche Bankand Lazard.LBC Credit Partners—The middle marketfinancing firm added John Jadach to its officeas a vice president to oversee new debtinvestments.Prior to joining LBC, the debt veteranworked with JPMorgan and Wachovia, aswell as Aon and Marsh & McLennan. LBCCredit just closed a $645 million fund.Loughlin Meghji + Co. — The firm hastapped John Krupar to serve as a managingdirector and head of the firm’s performanceimprovement practice.Krupar was most recently a partner withthe Oliver Wyman consultancy. He also put instints at Citigroup, General Electric and KaiserAluminum and Chemical Co.Moelis & Co.—The investment bank addedto its new Australian office by hiring two managingdirectors. Andrew Pridham, who becomeshead of Australian investment banking,joins from JPMorgan Australia, wherehe was executive chairman of investmentbanking. John Steinthal was appointed headof equities for Australia and was most recentlya co-founder and principal of EdwardBaillie Capital.Pridham spent six years at JPMorgan,and previously worked for 12 years at UBS.Steinthal, who co-founded Edward BaillieCapital in 2004, is a 14-year UBS veteran.Morgan Keegan—The investment bankannounced the formation of a new, broaderinvestment banking division to be headed by31-year company veteran Robert A. Baird.The move is intended to centralize its existingequity and fixed-income investment bankingoperations.Baird joined the firm in 1979 as one of itsfirst investment bankers.Pamlico Capital — The former in-houseprivate equity arm of Wachovia Capital Partnershas spun out into an independent firm.The entire team is staying in place followingthe spinout.Pamlico, which will continue to manageover $2 billion of assets, is funded by WellsFargo and a number of institutional investors,including AlpInvest, HarbourVest, LexingtonPartners and Partners Group. These institutionalfirms originally committed capital tothe group in 2007.Led by managing partner Scott Perper,Pamlico will move its operations to new officesin Charlotte.Primus Capital Funds — The Clevelandbasedinvestment firm promoted WilliamMcMaster to director.McMaster joined Primus in early 2008 fromWaud Capital Partners, where he was a vicepresident. Before that he spent time NationalCity Equity Partners as a senior associate.At Primus, McMaster was previously aprincipal. He focuses primarily on the healthcare,education and financial services sectors.The Riverside Co. — The private equityfirm bolstered its presence in education withthe hiring of Bob Bowen, who joins the firmas a senior advisor.Bowen previously spent over 40 years inthe sector, with a long stop at McGraw-Hill.This does not necessarily represent anew initiative for Riverside, which has notchedover 20 investments in the education spacethroughout its history.William Blair—The Chicago-based investmentbank hired Mark Watt to join its SanFrancisco team for Internet and digital mediabanking.Watt has 14 years of investment bankingexperience. He has worked with America’sGrowth Capital, where he was a partner andconcentrated on technology investment banking,and worked at TriplePoint Capital andMerrill Lynch prior to that.Windjammer Capital Investors — Theprivate equity firm promoted Greg Bondickand Derek Watson to managing director andCraig Majernik to principal.Bondick and Majernik are based in thefirm’s Waltham, Mass. office, while Watson islocated in the firm’s Newport Beach location.60 MERGERS & ACQUISITIONS May 2010

THE PULSEWhen the Levee BreaksACG members discuss where the next asset bubble may be formingThe most over-hyped segment is healthcare,but parts of healthcare may be “under-hyped.”What does that mean? Healthcare is one of thefew real growth opportunities, because of thebulge-bracket of aging baby-boomers. One oftencitedstatistic is that 13,000 individuals will turn60 each day, for the next 20 years. Additionallymore people will be using more services underthe new healthcare legislation.The challenge is that three things are likelyto come out of this. Healthcare is expectedto increase significantly as a percent of GDP,which will cause pricingpressures onproviders of servicesand ultimately onequipment and supplycompanies. Secondlyno one reallyknows how the payersystem will react -Donald J. Feldmannespecially Medicareand Medicaid, butprivate pay as well.Finally no one knows what the new regulationswill do to the system. The opportunity is that ifyou are the low-cost alternative for services andequipment, and your services or equipment providea real benefit to the healthcare consumer,you probably have a great opportunity.One of our clients provides a low cost equipmentalternative to healthcare institutions, whichshould be a unique opportunity. So healthcare isoverhyped, but you can win by being selective.—Donald J. Feldmann, President and CEO,Rippe & Kingston Capital Advisors—————————For decades, manufacturing companies haveset up related party entities to own and leaseback the manufacturing facilities. This structurehas provided both taxand leverage benefits.With the pastreal estate boom,John P. O’Connormany companiesleveraged the relatedparty owned real estateto fund corporatedevelopment projects.As market valuesdecline and businessslows, thechallenges of the renewalprocess will include lower real estate valuesand lower rent levels. Both of these factorscould limit financing options going forward.Also, in a transaction situation, buyers maybe less willing to assume the related party facilitylease which could leave the seller withless rent or a vacant building.—John P. O’Connor, Partner,Plante & Moran, PLLC—————————The next asset bubble is US Governmentdebt. The price of US Government debt has risenand the yield or interest rate on that debt has fallento unprecedented levels. The US Governmentbond market is the largest fixed income marketin the world and when rates rise and values fallthis will be the asset bubble of all asset bubbles.The US Government is spending moneylike a drunken sailor and has increased the annualdeficit from $300 billion to more than $1.5trillion. Total government debt has also balloonedto more than $12 trillion.The US does not have this money and duringthe next few years, interest rates on US Governmentdebt will rise rapidly and the value ofTreasury bills, notes and bonds will fall in tandem.This government spending cannot last andI believe it will blow up in the next few yearswith massive increases in interest rates to attractbuyers for our debt. When this occurs, the priceof Treasury securitieswill fall dramatically.Many institutionshave been buyers ofTreasury debt forsafety, yield and becausethere is a generalskittishness inthe world. They however,may be very disappointedwhenJoseph J. Orirates start rising. The10-year Treasury Note is currently around 3.9%and could rise to 5% or more which wouldequate to a loss of 30% in bond principal.—Joseph J. Ori, CPA, CFA,Senior Vice President, Commercial RealEstate, NRC Realty & Capital Advisors, LLC—————————In my opinion, it appears asset bubbles inreal-estate, stock and currency markets, especiallyin Asia, are a concern. The major reasonfor that is the very low interest rate of the US dollarand the fact that some economies in Asiathat are rebounding faster out of the globaldownturn are helping investors to borrow in dollarsand invest in real-estate, stock, and currencymarkets.According to the Wall Street Journal, TheWorld Bank warned in November 2009 that thesudden reappearance of billions of dollars in in-62 ACG > MERGERS & ACQUISITIONS May 2010

THE PULSEvestment capital in East Asia is “raising concernsabout asset price bubbles” in equity marketsacross Asia andin real estate in China,Hong Kong, Singaporeand Vietnam.Also in November2009, the InternationalMonetary Fundcited “a risk” thatsurging Hong KongAlberto Machadoasset prices are beingdriven by a floodof capital “divorcedfrom fundamental forces of supply and demand.”As several economies around the world pumpedmoney into their countries’ financial system tominimize the impact of the global slowdown,the economies that are rebounding have a tendencyto overprice assets. These countries needto take a closer look at their policies to avoidthe risk of another localized asset bubble.—Alberto Machado, Managing Partner,Latin America and Global M&A Practice,Opus Global Group—————————The next asset bubble is the wind energysector. This sector hasbeen hyped as a costeffective and renewablealternative tofossel fuels. The costto create and distributeenergy from windsources will be prohibitivemuch likeethanol has been.David Onion—David Onion,CEO, Chicago Capital Holdings, LLC—————————In one word: China. I see similarities to theInternet and real estateasset bubbles.Whenever I begin receivingconsistent investmentadvice fromlocal cab drivers, thewriting is on thewall.—Lora LindseyBarabash,Lora Lindsey Barabash Managing Partner,Ambriel Advisors—————————

COMMUNITY COMMENTARYStrategies for Corporate ChangeA structured approach allows executives to see where the organizationis going and howBy Jeff Schoon and Kevin HallJeff SchoonIn the recent economic crunch many companies struggleto make the business changes required to sustainthe required cash flow.One recent example comes to mind. While workingwith a company that generates roughly $100 million inrevenue per year, part of a muchlarger corporation, several traditionalpractices were observed.The site management was drivingthe business from a few key metricsincluding quality, days of inventorycompared to sales, productionper associate, on timedelivery, safety and a couple others.The metric goals were providedby corporate and werebased on the previous yearÕs performance.But when the economytook a turn, the site lost a substantialamount of volume. As inmany cases when the volumedropped, 25% in this case, corporatemandated a 25% reductionin head count. And just asyou can read in numerous turnaroundmanagement texts/publications, the managementteam broke the associates into three groups:_ A) Associatesthat are required for the business, B) Associates thatare good but borderline in terms of need, and C) Associatesthat are expendable.This company reacted quickly and made the 25% cutsto keep the costs aligned with current business conditions.But the company faced the same problems many organizationsface. After making cuts, they struggled to sustain customerservice levels, keep overtime down, and sustain productivitymeasures. Like many organizations, the supervisorsand managers struggled to identify the key drivers for thebusiness, construct a vision, and follow a strategic plan.After working with many companies, there is a clear,systematic approach to achieving success in a transformation,whether facing losses or raising positive earningsanother 10 points.During difficult times, organizations feel pressure tomake changes, and because ofpressures, management does notalways follow a process or developa detailed strategic plan.The first step is to understandand define business objectives.Unfortunately, this step is oftenoverlooked, is rushed, or is notfully conveyed. Some companiessimply state they will becomemore profitable or reduce costsby a certain percentage. Theseexamples are often unrealisticand difficult to align or developa plan toward. In turn, the organizationneeds to understand whatpotential changes will impact thebottom line.At one recent transformation,an executive team started with astructured approach, outlining the process first. Then theteam targeted high-level items such as sizing operations tocurrent market conditions, designing built-in flexibility, synchronizinglogistics and operations, and providing largestepimprovements in cost, quality and service. The companywas very successful in understanding what was goingto impact the business performance._They identified keybusiness metrics, the manufacturing and business processvalue streams, and identified the business performanceimpact of each value stream. This ensured all were workingon the right systems for achieving business objectives.To help better understand and develop business objectives,management needs to focus on the entire value“ Identify keymetrics at theassociate levelthat will drivebehaviors.”64 ACG > MERGERS & ACQUISITIONS May 2010

COMMUNITY COMMENTARYchain and identify which value streams will havethe greatest profit and loss (P&L) impact. For example,at one company, after identifyingthe business process and manufacturingvalue streams, themanagement team went through anddefined the P&L impact for each value stream.Prior to the analysis, the management team wasgoing to focus solely on the manufacturingprocesses. But, after reviewing the analysis, theorder-entry through accounts-receivable valuestream had the largest impact to the P&L.Once there is a good understanding of whatneeds to be accomplished and where to focus resources,the organization then goes throughstrategic alignment. Here, associates identifythe current state, analyze the detail data and designa future state vision. The vision should identifythe inner workings of the system. For example,based on current markets, managementshould be able to identify the capability of runninga mix of products, the number of associatesrequired, specific process flow, and inventory requirements.More importantly, management mustidentify key metrics at the associate level that willdrive behaviors, and they should utilize visualsthat will allow for quick identification when somethingis going wrong.Strategic deployment of the vision, or generatingand sustaining momentum and results,is a problem area for many organizations. Toachieve the vision, this process cannot be treatedas a project or a program. The vision needsto become the way we operate our business. Byaligning the organization to the vision we areable to simplify reporting, and we strategicallydeploy the organizational and system changesin a sustainable manner.In the previous example the company_ssales were down 25%, and the company quicklyreduced their headcount to offset this drop. Butthis caused a ripple effect in many other areas,because they didn’t fully understand the impact.Many organizations skip or give lip serviceto designing the system during strategic alignment.But in many cases, when done correctly,business objectives and a detailed vision canbe developed in two to four weeks. In the longrun, a structured approach will allow the entireorganization to simply and easily see where theorganization is going and how. Before making“Focus on the entire value chain.”changes, companies need to understand and developbusiness objectives that are going to transformthe business performance. They need togain strategic alignment through a systematic futurestate vision and strategic deployment allowsthe organization to achieve performance.Finally, companies must develop managementsystems that will support andimprove the future state system thathas been implemented.Jeff Schoon is a managing partner at Partnersin Corporate Growth, while Kevin Hall is a PCGaffiliate.May 2010 ACG > MERGERS & ACQUISITIONS 65

COMMUNITY COMMENTARYBlue Chip Recruits and Deal FlowA rundown of the best practices for private equity business developmentprofessionalsBy Mark JonesThe first Wednesday in February may notmean much to a majority of the population,but to rabid college football fans itis one of the two most important days of theyear. In these circles, folks prefer the simplemoniker of Signing Day. This is the day whenFlorida tries to ink another Tim Tebow and whenUSC hopes that the next Reggie Bush will committo wearing cardinal and gold. Signing day isthe culmination of years of legwork by coacheswho have combed the countryside looking forSaturday’s future superstars and spent many aFriday night in small town high school standsfrom Pahokee, FL to Abilene, TX.On the private equity gridiron, a large portionof the responsibility for signing up the nexttriple digit IRR deal falls on the LBO road warrior,the business development officer (BDO). AsPE has become an increasingly crowded fieldwith hundreds of millions in un-invested capital,most middle market LBO shops have institutionalizedthe BDO position to a level where it is acritical aspect of the business model. One couldcertainly argue that private equity is in the “maturestage” of the four-stage product lifecycle.Brand differentiation is critical at this stage andbusiness development is no exception.During my fifteen years in the PE BDO arena,I have seen many different models for dealgeneration. Whether the function be centralizedunder one person in one location or spread acrossseveral professionals in a multi-office format;whether staffed by junior marketing associatesor by partner level decision makers, there arenumerous ways to keep the pipeline full. Whateverthe model, are there any common keys toa successful business development effort? Toanswer that question, I solicited perspectivesfrom a handful of PE and investment bankingfriends. These industry veterans had great insightsinto what works best when it comes to PEmarketing (getting your firm on the deal flowradar) and sales (closing an acquisition).When I got into this business, I certainlyMark Jonescould have used a copy of “DealFlow Generation for Dummies.”Instead, my partners simply toldme to go find some good companies to buy. Thatwas helpful. Jim Marra, Director of BusinessDevelopment at Blue Point Capital Partners,would counsel a new BDO to figure out a fewthings before starting to rack up the frequentflyer miles. First and foremost, determine yourfirm’s “deal box” in terms of preferred size, industries,situations, geography and pricing metrics,as well as what quickly kills a deal in yourshop. This information will more efficiently focusyour efforts and save your most scarce resource—-time.You will also be able to moreeffectively communicate your “message” to yourtarget audience. In a world of 1,500-plus PEGs,your message should be simple to articulate aswell as consistent in presentation and application.“Style drift,” in investing parlance, can bebad for biz dev, not to mention what your LPswill think. The reality is that the market will decideyour “center-of-the-plate deal” and it isyour responsibility to steer that decision. Withouteffective guidance from the BDO, an intermediarymay simply choose not to present adeal to a PE shop under the assumption that itis not a fit.Familiarity breeds comfort, so seeing moredeals starts with showing up. Bo Briggs, amanaging director at Croft & Bender, says thateven in 2010, shoe leather matters. I have alwaysbeen a big believer that nothing beats aone-on-one meeting in an investment banker’soffice or over a meal. If I am meeting an intermediaryfor the first time, what do I want to accomplish?Succinctly put, I want to convey my“This industry creates too much hubris.”firm’s strengths and take a first step towardbuilding a relationship.Dave Dunstan, a managing director atWestern Reserve Partners, relays that everyoneis smart and everyone has money, so thePEGs who try to build relationships stand out.One guiding hint is that approaching a meeting66 ACG > MERGERS & ACQUISITIONS May 2010

COMMUNITY COMMENTARYfrom the perspective of “tell me about you andyour firm” is much better than “let me tell youabout how many good deals we have done.”Along those same lines, check your ego at thedoor. One investment banking pro bluntly toldme that this industry creates too much hubris. Hebelieves that we are all salesmen, so what’swith the attitude? Remember that, to this intermediary,you ARE your firm and that everyword and action is being viewed from the perspectiveof “do I want to introducethis PEG to one of my valuableclients?”A fellow PEG BDO who metme for the first time gave me afirst hand example of a commentthat could be misconstrued as condescending.He asked where I was from and I replied “Chattanooga.”With a smirk, he asked if we had anairport. I’m not sure he had a clue as to howbadly that comment came across and I wonderedhow he interacted with intermediaries.And, just for the record, we do have an airport(although it may be closed on Wednesdays inthe summer).One issue that was consistent in my discussionswith i-bankers is that they prefer dealingwith someone who speaks for the firm. The BDOdoesn’t necessarily have to be at the partnerlevel, although it helps, but should be able tosay what deals a firm will or will not do. Thismeans being able to ask some basic questionsto determine if the deal is a total non-starter.Investment bankers grow increasingly weary ofempty suit book collectors, ie., very junior peoplewho want to see every CIM. By the way, acouple of comments on meeting manners areworth mentioning. One, don’t have your secretaryset up the meetings. Most i-bankers appreciatea personal email to which is attached aone page firm summary that communicates thefirm’s salient aspects. Two, showing up is good,but showing up or calling every two months toask what is new can be a bit “smothering.” Thesame advice goes for marketing email — lesscan be more. Finally, if something comes from themeeting that requires follow up, don’t let it slipbetween the cracks.Doing more than city marketing blitzes is areality for many BDOs. This extra effort meansattending a variety of industry conferences, writingarticles, speaking on panels, and then some.I have attended an incalculable number ofM&A/PE events where deal sources are present.I have spoken as a moderator or panelist atevents hosted by ACG Chapters, Buyouts, AMAA,IBBA, CFA, FEI, TMA and even the local Chapterof the Tennessee Society of CPAs. I mentionthese efforts not to grandstand, as, guess what,“Brand differentiation is critical at this stage andbusiness development is no exception.”there are a lot of other PE BDOs who do thesame thing in an effort to widen the top end ofdeal funnel. Does this mean occasionally pushingone’s comfort zone? You bet. But, over time,you get used to it and, in some twisted way, youmight start to enjoy taking unscripted questionsfrom a large crowd.I should mention that if you are going tospeak in public, remember that your audiencemay not be homogeneous and could contain a varietya constituencies so be careful what yousay. I saw this scenario first hand on a panel inNYC where one of my fellow panelists, the presidentof a very well known middle market PEgroup, addressed the audience as though it wascomprised solely of LPs. I make this assumptionas he boasted about not participating in auctions(I guess he’s found the secret stash of proprietarydeals) and only paying low multiples forcompanies. As I looked around the room andsaw a number of deal sources, I had to wonderwhat the heck he was thinking. As to maximizingthe benefits of attending conferences, whichcould be an article unto itself, the BDO shouldremember their college exams — the bestgrades came on the tests for which they weremost prepared. In other words, do your homeworkto fill your days with productive meetings,schedule lunches and dinners and watch out forthose late nights. Another way to stand out fromthe crowd is to host an annual marketing eventthat is truly unique. A great example can befound every winter on the frozen Minnesota watersof Lake Mille Lacs where the mezzaninefirm of Northstar Capital hosts its unparalleled“ice fishing” excursion.When an intermediary wants to introduceyou to a deal, for goodness sakes be responsive.Alex Mammen, a managing director withTM Capital, asserts that investment bankerswalk in the shoes of clients and lack of responsivenesscan be a harbinger. This part of theprocess is another area where seasoning helpswith knowing the handful of importantprovisions in a CA as wellas if a given deal is consistentwith the firm’s strategy. And thisincludes add-ons as well as platforms.If an existing portfolio isnot in acquisition mode, then say so. The samegoes for a platform company that is in an industrywhere there is negative institutional memory.Phil Curatilo, a principal with Key PrincipalPartners, relates that the market needs tobe confident in your ability to screen deals. Beingresponsive is certainly important, but balanceresponsiveness with giving the deal a fareshake. For example, a turn down after quicklyskimming the executive summary doesn’t count.If that’s all it takes, the CIM shouldn’t have beenrequested in the first place. Once the deal passesthe “sniff” test and goes into the process forserious review, the real analysis starts. This internalaspect of business development is thepart of the sausage factory that most i-bankersdon’t see, but is so critical. Figuring out whichdeals to really chase is a learned art. There aregood deals and then there are good deals thathave a reasonable likelihood of closing.Further, pride of authorship should be avoidedsuch that a deal is not my deal or your deal,but our deal. Assuming the presence of a teammentality, someone in the firm still needs to bethe deal’s sponsor by taking ownership in it. TheBDO that assumes this sponsor role can fostera level of trust with his colleagues at this pointby being smart on the major issues surroundinga potential investment such that they can be intelligentlydiscussed in a deal vetting meeting.And the BDO shouldn’t be thin skinned by toughquestions from colleagues. Trust me; your LPsMay 2010 ACG > MERGERS & ACQUISITIONS 67

COMMUNITY COMMENTARYwill appreciate a healthy dose of skepticism. Arecommendation to BDOs on the internal saleprocess: don’t rush your partners to make a decision.As one of my old bosses used to say: “Ifthe answer has to be today, then the answer isno.” One piece of advice for the “internal” partnersof a PE shop is that perfect deals at perfectprices are virtually mythical. As such, if youare waiting for a fast growing, high margin companywith no competitors and no material weaknessesthat is priced at four times Ebitda, you’llbe waiting a while.When BDOs relay a decision not to pursuea transaction, they face one of the hardest partsof the job: saying “no” in a manner that is notdetrimental to the relationship. After all, “donot call lists” are a reality. Make it is obviousthat you devoted enough time to arrive at yourdecision. Tell the deal source specifically whyyou are taking a pass. Furthermore, suggest otherpossible buyers, PEGs or strategics. I oncepassed on a transaction, but suggested severalother PE groups as alternatives. One of thosePEGs ended up being the buyer. That’s a quickway to build a long-lasting relationship.Alan Mayer, a managing director withGMB Business Advisors, relates that a PEGonce made an executive in residence availableto discuss a specific industry and help identifyalternative buyers. That PEG now sees all ofAlan’s sell-side opportunities.Bottom line, no interaction concerningone deal should beabout one deal. The focusshould be on the relationship, as that deal sourcemay present a PEG with dozens (or more) of opportunitiesin the coming years.Assuming a PEG submits a compelling indicationof interest (IOI), the next step is to meetcompany management. In the deal world, managementmeetings might be the closest thingwe have to “show time” since a lot can go rightor wrong as emphasis shifts from marketing tosales. The broad advice I would relay here is:One, be prepared. Two, be ready to sell. Three,everyone you bring to the meeting will be a reflectionof you. Preparation may sound like commonsense, but an i-banker confided to me thateight PEGs are often invited and four are unprepared.The wise PEG will do a lot of homeworkon the people and the company.Starting with the people, Eric Malchow, amanaging director with Lincoln International,recommends asking for a dinner the night beforeas a way to develop a social rapport beforethe meeting. I would add that if you ask for sucha dinner, and especially if you order a bottle ofScreaming Eagle Cabernet, don’t get alligatorarms when the check arrives. In terms of preparation,asking insightful questions is a sure wayto convey your level of homework. And this goesfor all of the PEG attendees. You’d be surprisedat how many i-bankers told me about PE partnerswho obviously “outsourced” the meeting preparationto the junior professional.Jason Payne, a managing partner withMainsail Partners, relays that his goal is tonot necessarily to overwhelm management withnumbers of questions, but to ask the three “right”questions so as to convey that he “gets it.”Meeting preparation should include asking thei-bankers for insights into any situational dynamicsthat might not be obvious in a CIM. Muchinformation is relayed in these meetings, butDavid Santoni, a partner with Prestwick Partners,maintains that someone from the PEG betterbe able to sell. Especially in a case wherethe incumbent management will retain equity,the effective articulation of a PEG’s track record“Don’t get alligator arms when the check arrives.”and value-add can be nearly as important asmonetary consideration. In all managementmeetings that my firm attends, we present theresults of every investment we have made inour 20-plus year history. More than a few investmentbankers have complimented us on thislevel of transparency. After all, it is transparencythat can allay fears of the dreaded retradedown the road.A wise PEG is mindful that, in the eyes of theseller, the lenders or industry “experts” that thePEG invites to the meeting are viewed as beingmembers of the PEG’s team. Accordingly, rulesof the road should be established in advance ofthe meeting so as to avoid any potential breechesof decorum. Most every investment bankerviewed the “industry expert” concept as a riskyproposition at this stage. It can be a positive interms of industry knowledge, but can also be ahuge negative if the individual comes across tomanagement as “this is how things should bedone”.Bud Applebaum, a principal at WingatePartners, feels that if an industry expert or operatingpartner is at the initial meeting, it is crucialto get management from “what’s this guy’srole?” to “this guy could really help me.” Aboveall, remember that this stage is the first step towardestablishing a relationship with a managementteam that may only go through such aprocess once in their careers. As such, treatthem, and the investment banker, as the most importantpeople in the room.Bill Glastris, a founding principal atProspect Partners, strives to convey that beinga boss is easy, but that Prospect knows howto be a partner. Further, when a managementteam looks back on an experience with Prospect,Bill wants them to remember the partnership,the respect and value-add that they brought tothe table as well as the capital.Following the management meeting, somebuyers drop out and some sharpen their pencilsin hopes of gaining exclusivity. Unless a buyeris offering to pay a materially higher price withno closing contingencies, theprocess remains competitive.Some truisms: the LOI shouldbe consistent with the IOI, specificityis critical, as is understanding & addressingall of management’s “hot buttons”, contingenciesshould be minimized, due diligence (timespent in the data room as an example) should bemaximized and enthusiasm about a deal helps,so show it. Every company has “issues” andthe smart PEG conveys a knowledge of and comfortwith these issues as another way to exhibitcertainty of close. Don’t expect to sign the LOIand then hire a third party consultant to validatethe business plan — that’s the kind of workthat should have already been done.The wise PEG does plenty of due diligencebut also realizes that an investment banker whoperceives “paralysis by analysis” is likely to go68 ACG > MERGERS & ACQUISITIONS May 2010

COMMUNITY COMMENTARYin another direction. Reinforcing this need forcertainty, many entrepreneurs are growing fatiguedof the process at this point so PEGs shouldbe sensitive to this situation. Ultimately, an investmentbanker will advise the seller to considertwo key questions: one, with whomdo I want to partner for the next five or moreyears, and two, who is most likely to getthis done?A comment on valuation is also worthmentioning. All investment bankers agreethat the buyer is most definitely not alwaysthe high bidder. Although I couldn’t get a quantitativeanswer to the question of “how muchlower is too low”?, I feel it safe to say that $40million will probably not beat $50 million, but$46 million just might depending on the numerousother transactional issues. After all, it is thebanker’s goal to balance the best match of economicsand chemistry since satisfied sellers arean excellent referral source.Over the years, I have learned a few thingsthat are applicable at a variety of points in thebusiness development process. Everyone is apotential deal source so your professionalismshould be pervasive and consistent. If an intermediaryyou have never heard of contacts youwith a deal that is not a fit with your firm, respondwith a polite email that is copied to otherprincipals at the firm. This simple act is importantas some firms centralize relationships whileat others it is more specific to each banker. Anythingyou can do to stand out is an attribute. Forexample, if your conference registration includestwo attendee slots, offer the second one to alocal intermediary. If a company contacts youdirectly for capital, refer them to a few good intermediaries.If an intermediary mentions thatthey are having a hard time financing a deal, offersome names of lenders who might be interested.Relationships can take time, so keep at it.Occasionally, you won’t connect with a particulardeal source for some reason. That’s okay. Inthe age of technology and social networking,don’t underestimate the power of a handwrittenthank you note. Let a deal source get to knowyour colleagues as it is another way to deepenthe relationship. The firms that excel at businessdevelopment often have a firm-wide salesculture and an appreciation for the competitivenessand ever-increasing level of market efficiencies.Paul Sperry, co-founder and presidentof Sperry Mitchell, reminded me that“Your message should be simple toarticulate as well as consistent inpresentation and application.”their clients pay them for their judgment. Assuch, don’t give a deal source any reason toquestion yours.Finally, and this is perhaps one of the mostimportant aspects of business development sinceit relates to continuous improvement, learn fromyour peers. It is impossible for me to articulateall that I have learned from the ladies and gentswho do this job well. I’m not about to namenames as I’ll surely forget someone, but to allthose folks with whom I have partnered on intermediarydinners, shared war stories of howmany marketing calls can possibly be squeezedinto one day (I think my record is ten includingthe early morning run with an i-banker)or commiserated about a cancelled flight,I thank you for your friendship and wisdom.Oh yeah, I mentioned Signing Day asone of the two most important days of theyear for us college football nuts. So what’sthe other one? Well, the first big kick off weekendthis Fall is September 4th. I can’t wait.Mark Jones is a Partner with River AssociatesInvestments, LLC, a lower middle market privateequity firm in Chattanooga, TN. He serves onACG’s Global Board of Directors and was Chairmanof Intergrowth 2008.ACG AwardsRecipients to be honored at InterGrowth 2010,May 4-6 in Miami Beach, FLACG Lifetime Achievement AwardCharles W. Downer, founder of C.W. Downer & Company2010 Meritorious Service AwardDan Amadori, Stuart Gruskin, Mark Jones, Jim Marra,and Harris SmithACG President’s Award for Excellence and Achievementby an ACG Chapter ExecutiveJoan McCarthy, Chapter Executive, ACG ClevelandACG Chapters of the YearACG National Capital, ACG St. Louis and ACG Raleigh DurhamMay 2010 ACG > MERGERS & ACQUISITIONS 69

PINCHED continued from page 27Indeed, perhaps the biggest issue in the fundraising market todayis the fight over what can be considered ‘market’ terms. The InstitutionalLimited Partner Association (ILPA) fired a shot across thebow last September when it unveiled a 15-page document outliningbest practices for limited partners. It isn’t the first time a set of “guidelines”have been conceived, but this time around — perhaps due tolimiteds’ growing muscle — the debate blew up.A story in the Wall Street Journal, identified in March that a fewlarge funds have even hired legal counsel to explore antitrust claimsagainst the limiteds, and later that month, a sit-down between heavyhitters on both sides, including David Rubenstein of Carlyle Groupand Calpers’ Joseph Dear, among others, took place to clear the air.To be sure, the negotiations between limited partners and privateequity firms over terms are becoming more and more difficult.GPs are already feeling pinched by the likelihood that they will nolonger be able to treat carried interest as capital gains, and if fund sizesare decreasing or staying static, that translates to lower fee income.LPs, however, do not want to see sponsors pass along any addedcosts, and given the dislocation, many are factoring in more risk todaywhen it comes to making large commitments to blind pools.“Lots of things have changed in the past couple of years, says KathyJeramaz-Larson, executive director of the Institutional Limited PartnersAssociation. “Private equity is not isolated from making thesechanges too.”Some of the modifications outlined in the ILPA guidelines includestrengthening clawback provisions, and guiding GPs to maintain asubstantial equity interest. Transaction and monitoring fees were alsocited, directing LPs to push for that income to “accrue to the benefitof the fund.”Jeramaz-Larson, however, downplays any talk of collusion. “Theprinciples [outlined] should establish a communication that allowsGPs and LPs to talk frankly about things they don’t agree on,” she says.Even outperforming PE funds, however, are being swayed. WhenTA Associates wrapped up its most recent fund last August, the firmfinished the fundraising well ahead of its specified target. That didn’tstop the firm from making some concessions in the form of alowered carried interest (trimmed to 20%) and a provision that redirectsits transaction fees to offset the management fees paid by limiteds.David Dinerman, chief financial officer with Probitas Partners,notes that it goes back to aligning interests. “The LPs are lobbyingfor more upside to be wrapped up in the success of the fund.”Still, most observers recognize that while LPs may eschew generalpartners who don’t comply, they will not back so-so funds onthe basis of attractive terms. What that means is that the name ofthe game, like past eras, is about finding the top quartile performers.As the economy continues its recovery, the industry will slowlyrebound as well. Fund sizes will still shrink and the poor performerswill likely get pushed out as well. The question facing GPs and LPsalike, however, is who remains in the market and how does it shapethe asset class for the next ten years.KICK THE CAN continued from page 55come true. In fact, given the $1.5 trillion of non-investment gradedebt maturing over the next five years and the record amounts ofcapital that financial and strategic buyers have available to put towork, it seems quite likely that the level of distressed M&A activitywill pick-up considerably over the intermediate term. Time will certainlytell, but recent trends suggest that the era of kicking the candown the road is coming to an end and a strong distressed M&A cyclemay be at hand.Geoff Frankel, Managing Director at Harris Williams & Co., leads the firm’srestructuring advisory practice. He has over 20 years of experience advisingtroubled companies and their creditor and equity-holder constituenciesin mergers and acquisitions, financings, corporate reorganizations,debt and equity restructurings, and complex valuations.Harris Williams & Co. (www.harriswilliams.com) is a member of ThePNC Financial Services Group, Inc. (NYSE:PNC). The firm is focusedexclusively on the middle market providing sell side and acquisition advisory,restructuring advisory, board advisory, private placements and capitalmarkets advisory services. Harris Williams & Co. is the trade name forHarris Williams LLC, a registered broker dealer. Member FINRA andSIPC.EARNOUT continued from page 49of dealmakers, that’s worth the risk of litigation that may occurthree or four years down the line.Doug Nakajima, a managing director at consultancy LECG,notes that at the end of the day, buyers aren’t going into a deal withdesigns on side-stepping an earnout. The provisions are used becausethey offer protection to the buyers, who may be unsure abouta sellers’ projections. In most cases, the acquirer wants to pay theearnout because it generally means the acquisition met its objectives.“It can save the deal,” Nakajima says. And that’s what makes itso valuable in an uncertain market. “It allows both sides to get thevalue they think they can get,” he says.70 MERGERS & ACQUISITIONS May 2010

ROUNDTABLE continued from page 47Zussman: The issue right now, in mid March, is that there is just somuch uncertainty in terms of what is going to come out of it. There’sbeen so much talk about the regulatory process and how involved it’sgoing to be, whether it’s higher capital requirements or other initiatives,but there is no certainty to any of it.That’s probably affecting groups that may want to come into themarket but are not sure what’s going to happen. For the traditionallenders that are already established, I don’t see it having much of animpact.Mergers & Acquisitions: Is that one of the reasons some of the newergroups that were able to procure equity have had so much trouble gettingthe leverage necessary?Russell: I don’t think the regulatory issues are blocking the leverage.The banks, insurance companies and hedge funds, who provided allof the leverage in the past, are still dealing with their own issues.Winterer: On the regulatory side, just to reiterate, where there couldbe a potential impact, is on the depository institutions and what sortof lending they can do. My understanding is that the regulators areevaluating it on an institution-by-institution basis.We actually went to secure an amendment for one of ourportfolio companies that would have increased the leverage. It’sa pretty strong business with low leverage, so it’s a bit of a nobrainer,but we have a small regional bank in the syndicate andthey came back to us and said they couldn’t approve it becauseof the regulators. This is a small regional bank, and I don’t thinkit’s as much of an issue at the bigger regionals, but clearly this ison regulators’ radar screens.Russell: Another wrinkle that will be interesting is on the CLO side,related to the whole onshore/offshore tax question. So much moneysupporting the CLOs came from outside the US, from Europeaninsurance companies, hedge funds, banks as well as Asia. That moneymoved to the US on an offshore basis, supporting the CLO market.I know there have been some discussions around that, whichcould have a dampening effect on a potential CLO resurgence.Mergers & Acquisitions: Let me ask, while the downturn is still freshin people’s minds, what are some of the lessons learned from the credit crisis?Crosby: For me it’s probably two things. The ‘partnership’ issue isimportant. We’ll remember who behaved the best and helped usthrough the difficult situations. Some of the regional banks and someof the CLOs — be it for structural or regulatory reasons or just acommitment to the category — weren’t as flexible.The other consideration goes back to voting requirements. Devonalluded to it earlier, but the difference can be significant whenyou’re talking about a direct lender vote, a 51% vote, or two-thirds.In a couple of difficult situations, when you’re dealing with directlenders, you had a lot of alternatives and then there would be a lenderwho wasn’t being as cooperative. There are some things you can doin forbearance or through your amendment structure that provideda lot of flexibility.Zussman: I would agree with that. You know, one of the things wesaw during the cycle is that there were a lot of interim lender issues.The lenders were not necessarily a cohesive group. You had CLOs,you had lenders that came in and bought at a discount and everyonehad different objectives.There was a lot of examination into the documents to really determinethe direct lender issues. I think what you’re seeing now is afine tuning of the documents to make it more clear about who thedirect lenders are and what actions they can take.Specifically, there’s been some cases dealing with direct lenders whocan force the agent to credit bid in a deal. Most of the cases haveheld that an agent can do that for direct lenders but documents arebeing refined to make it more specific.You’re also running into issues on funding. Many documentsover the last couple of years have provided that each lender can makethe determination whether they can fund in a default situation ornot. I think you’re seeing a change in the documents — not completelybut in many cases — that require a direct lender to make the determination.People are also looking at the voter rights and taking a closer lookat who is in their group. If there’s a mezz investor in the group or asponsor turns out to be a lender, there may be some provisions thatlimit their voting rights to preclude them from interfering with thesenior lenders.Winterer: One of the lessons we learned is to stress test the lender’sbalance sheet; to really look at worst-case scenarios and how thatcould affect their ability to manage an asset.Mergers & Acquisitions: To close, does anyone have any thoughts regardinghow the next 12 to 18 months will unfold for the debt markets?Russell: I think the key variable over the next 12 months is going to bethe supply, the buyers and sellers. If that picks up, I think pricing willslow it’s descent. The terms and leverage might migrate marginally;maybe you can get a quarter term more leverage by the end of the year,but it won’t swing the same way pricing does. Generally, though, if volumepicks up, you’ll see a little stabilization in the market.Borow: I agree. The supply of quality deals coming to market is goingto be very key. There are some issues impacting that.Coming off of this lull, considering everyone looks at TTM, thereal question is how long will it take for some of those tougher quartersto fall off, so you’re going to market with a stronger trailing twelvemonths? Also, how many private equity firms are going to be backin the fundraising market next year that have to show some realizations?There are going to be a lot of things that could potentially drive thesupply of quality deals. On the buy side, people have spent so muchtime cleaning up the costs that now they have to be very focused onhow to drive the top line growth. I’m cautiously optimistic.May 2010 MERGERS & ACQUISITIONS 71

SYNERGY continued from page 12their supplier. This money flows to the bottom line pretty quickly,”Gell cites.Financial synergies, such as tax benefits, increased debt capacityor excess cash, are also usually easier to measure than operational efficiencies.As the markets transition from downturn to recovery, the attentionfrom buyers often shifts from cost to revenue synergies. It’s notthat boards ignore cost savings, but deals are increasingly prefaced ontop line growth. And given that revenue synergies aren’t bound by afixed cost, this is an area where executives can get too creative if they’retrying to rationalize a higher price to win a deal.Moreover, synergies of all types usually imply a best case scenario.In practice, Frankel notes, the exact numbers are much more difficultto determine. “The danger is to fall in love with synergies. Youhave to repeatedly diligence and refine the projections until you movecloser and closer to a concrete number,” he cites. Also, Frankel notesthat deal architects may overlook the required upfront costs that ittakes for buyers to realize synergies.COST CURVE continued from page 14op the Salar de Olaroz lithium-potash project. Toyota is pouring $4.5million into the effort to fund a feasibility study, and beyond that willown a 25% stake in the JV. The company also arranged an off-takeagreement that would put Toyota in position to purchase any of thelithium carbonate that comes from the mine, according to websiteBusinessGreen.com.It may be pretty far afield from manufacturing autos, but if itgoes smoothly, Toyota will solve a lingering question that shadows theshift to electric vehicles for auto makers. Lithium, a core componentto the batteries used by Toyota, is a difficult market to gauge as itdoesn’t trade on commodity exchanges.While deal pros probably aren’t keen on buying into a rising cycle,these backward vertical integrations may help companies avoidthe headaches that come with volatility down the line.Additional reporting by Ken MacFadyenJUNK DEBT continued from page 22With that said, market players note that despite this high level ofdistress, investors have returned to their old ways, and that the defaultrate has wound up being lower than originally forecast.“People said they would never do [dividend deals] again, but thedividends are back,” said the New York-based investment banker.“And the defaults came in lower than all the draconian scenarios hadpredicted. ... This whole amend-and-extend trend has kicked the candown the road.”Protections for bondholders, like change-of-control covenants,which have been standard in investment-grade debt deals, are now amust in the high yield market.“I don’t think there’s any question that bondholders are going tolook to grab back some of the turf they lost in the last cycle,” said NeilTownsend, a partner and co-leader of the private equity group oflaw firm Bingham McCutchen. “The covenant-lite and no-covenantstyle bonds, that pendulum swung way too far on that stuff and anysmart representative of bondholders is going to grab some of thatback. At the very least there will have to be some limitations on debtliens and protections for significant changes in capital structure.”According to a recent JPMorgan report, the year-to-date total asof March 19 reached $59.6 billion for junk bonds and $20.1 billionfor leveraged loans.Such large deal volume shows that investors are eager to buy debtthat comes to market, and market observers agree that there is a glutof demand. “Right now, there’s an imbalance. There’s not enoughsupply and a lot more demand,” says a New York-based investmentbanker. “We see very clear sailing at least through this year as far asdeal flow.”72 MERGERS & ACQUISITIONS May 2010