FINAL REPORT - Private Equity Dynamic Conditions

Private Equity Under Dynamic Market Conditions:
Portfolio Company Management & Key Deal Terms
November 2009
www.mergermarket.com
In association with
Contents
Foreword 03
Methodology 03
Analysis 04
The Purchase Price Earn-Out: Potential

Fuel for Dealmaking 17
Perspectives from an Investment Banker 20
Historical Data 25
About mergermarket 26
02 www.mergermarket.com
Distressed M&A Outlook
Foreword
Welcome to Private Equity Under Dynamic Market Conditions: While most respondents use the same amount of seller financing
Portfolio Company Management & Key Deal Terms, published by as they did two years ago, their reasons for using seller financing
mergermarket in conjunction with Akin Gump Strauss Hauer & Feld today seem to have adjusted to current market conditions. 54%
LLP and BMO Capital Markets. This survey highlights emerging of respondents say they use earn-outs primarily to address the
trends in private equity portfolio management and its professionals’ gap between buyer and seller expectations, a gap which 81%
usage of transaction terms, conditions and financing techniques in of respondents do not expect to narrow until next year. More
the current market. traditional uses for seller financing, such as incentivizing or
motivating management, are expected to be less prominent.
Deal terms have been subject to close scrutiny since the onset of
the financial crisis, due largely to their pivotal role in high profile Respondents’ approach to their portfolio investments also speaks
deals. The lapsed buyouts of Huntsman Corporation and BCE to current market conditions: more than half of respondents who
Inc., both of which lapsed largely because of material adverse are delaying planned exits intend to do so for at least one year, due
change (MAC) clauses and solvency issues, are just two examples largely to the unfavorable valuation climate for sellers. During this
of transactions that have impacted public awareness of specific time, 42% of respondents say improving operational performance
private equity deal terms. will be their primary objective.
Not surprisingly, most respondents have paid particularly close In terms of industry-specific predictions, the large majority of
attention to MAC clauses in the past year: 71% of respondents have respondents will not change their sector focus in the upcoming
incorporated MAC clauses into buyer closing conditions during this year. But of the respondents who do plan to change their sector
time, making this the most widely used closing condition among focus, the Consumer and Technology industries are each cited
respondents this year. In the year ahead, respondents expect to see by 67% of respondents as the industries they expect to gravitate
an increase in the usage of MAC clauses specifically as well as an towards in the coming months.
increase in the usage of buyer closing conditions in general.
Overall, the outlook for the upcoming year is optimistic. 81% of
The private equity industry has indeed been adjusting to the dried respondents expect valuation gaps between buyers and sellers to
up credit markets, but the industry has not necessarily become less narrow in 2010, with 45% estimating in the first half of the year and
aggressive. In fact, 61% of respondents say their targeted returns 37% estimating in the second half.
have remained unchanged for the past several years. Respondents’
This survey provides an in-depth look at how the private equity
use of seller financing to fund deals has also remained steady:
industry is applying specific terms and conditions to current
58% of respondents report that over the past year, seller financing
transactional activity, working around unprecedented financing
or earn-outs accounted for up to one quarter of the total purchase
difficulties and managing their current investments. We hope you
price, and 53% of respondents say seller financing or earn-outs
find this survey both useful and informative, and as always, we
account for the same portion of the purchase price on current
welcome your feedback.
investments as compared to 2007 or earlier.
Methodology
In the third quarter of 2009, mergermarket interviewed 75 senior level
private equity practitioners in North America to gauge their sentiment
on current portfolio management strategies and expectations for
negotiating deal terms in the current market. Respondents provided
invaluable insight into trends in the usage of specific deal terms, as
well as a detailed outlook for the upcoming year. All respondents are
anonymous and results are presented in aggregate.
www.mergermarket.com 03
Analysis
What are your top three preferred method(s) or structure(s) On average, what are your targeted returns for
for investing in this environment? What were your top three new investments?
preferred methods prior to the credit crisis?
90 85%
82%
80 Preferred strategy prior to credit crisis 10-14%
4%
11%
70 Current preferred strategy 15-19%
Percentage of respondents
20-24%
60
26% 25%+
50
40
33%
29% 31%
29%
30 25%
22% 22% 21%
20 18% 17% 17% 19% 17% 18%
10
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Despite the limited availability of debt financing, respondents’ 59% of respondents target returns of 25% or higher for new
preferred investment methods have generally remained unchanged investments, while approximately one quarter target slightly more
in recent years. LBOs have remained the preferred method modest returns in the 20% to 24% range. One executive explains
of investing for the large majority of respondents. In fact, the that poor economic conditions should not diminish investors’
percentage of respondents who cite LBOs as their preferred expectations, especially since investments made today will likely be
investment structure has remained almost exactly the same since long term, with exits planned for when market conditions improve.
the onset of the financial crisis, decreasing from 85% to 82%.
Additionally, minority equity investments in private companies and
bank debt purchases aimed at gaining control of a company remain
the second and third most popular investment methods, each cited
by about one third of respondents. Both of these methods were only
slightly less popular before the crisis.
Many respondents acknowledge a less favorable financing

climate for LBOs, but they consistently emphasize that financing
difficulties have not necessarily made LBOs less attractive. Indeed, Many commentators expected the turmoil in the credit markets to
respondents point out that their firms are now using alternative drive private equity sponsors from LBO structures to alternative
approaches but plan to become more heavily involved in LBOs when structures that were not as reliant on debt financing. Instead, the
the debt markets improve. principal impacts have been on deal size and valuations. The current
credit markets are more accommodating to middle market and
smaller transaction sizes and lower valuations support expected
target returns.
Akin Gump Strauss Hauer & Feld LLP
How does this percentage compare to your targeted returns What percentage of your time is spent on add-on
in previous years (2007 or earlier)? acquisitions for existing platforms, or otherwise
working with existing platforms to grow or stabilize
current offerings?
61% Equal to previous targets 45% Less than 24%

7%
Higher 25% to 49%
15% Lower 50% to 74%
75% to 100%
18%
24%
30%
Adverse market conditions have generally not caused respondents Respondents do not devote a significant portion of their time to add-
to be any less aggressive when it comes to targeted returns. 61% on acquisitions, or growing or stabilizing offerings for their current
of respondents say their targeted returns have not changed in existing platforms. The largest percentage of respondents (45%)
recent years, while roughly one quarter of respondents target higher devote less than a quarter of their time to these initiatives, followed
returns compared to the years leading up the financial crisis, most by nearly one third who spend between one quarter to one half of
likely driven by a heightened level of risk. their time in these areas. Still, it is worth noting that a quarter
of respondents overall spend between half to all of their time
One respondent who says his firm has been targeting higher
focusing on add-on acquisitions, or growing or stabilizing current
returns than usual over the past year says steeply discounted
investments.
distressed assets have allowed for higher expectations, as many of
these targets are undervalued but fundamentally strong companies. Several respondents comment that working with existing
investments is a priority at the moment, as exits are not necessarily
a viable option and add-on acquisitions tend to require financing
that is hard to come by in the current market.
We see our clients spending much more time on existing portfolio

companies. Much of the focus has been on delevering the balance
sheet, maintaining margins in the face of flat or declining revenues,
implementing cash conservation strategies and modifying
management incentive programs to reflect changed business
conditions.
What is the likelihood you will have to restructure an When making investments in the next 12 months, what
existing portfolio investment? percentage of the purchase price do you expect to fund
with third-party debt?
22% Very likely 5% 21% 1%-25%

4%
Somewhat likely 26%-50%
1% 16% Not likely 51%-75%
Will definitely not occur >75%
Already restructured or in the No debt will be used in the

process of restructuring an 46% upcoming year
47%
existing portfolio investment
14%
24%
The large majority of respondents (69%) believe they will likely have to Over the next 12 months, the largest percentage of respondents
restructure an existing portfolio investment in the year ahead, and an (46%) expects third-party debt to account for about one quarter
additional 16% have already done so or are in the process of doing so. to one half of the purchase price on new investments, followed by
Respondents stress that restructuring activity has been on the rise in nearly a quarter who say third-party debt will account for one half
recent months, and one respondent expects this trend to continue for to three quarters of the purchase price. A comparable 21% say one
at least two years. quarter or less of the purchase price will be funded by debt.
Surprisingly, financing difficulties seem to have a minimal impact
on respondents’ outlook for third-party debt funding in the year
ahead. But one respondent explains that while his firm expects to
rely somewhat heavily on debt financing for upcoming deals, his
firm has also adjusted its strategy in recent months to focus on
The survey’s results are representative of the general weakness smaller deals in the lower mid-market range.
in the global economy with operating performance at debt-laden
portfolio companies deteriorating over the last twelve months,
leading to severe liquidity issues and, in many cases, covenant
defaults. Unable to refinance in these tight credit markets, financial The robust LBO market in 2003-2007 has left many companies saddled
sponsors are seeking creative restructuring solutions to maintain with historically high debt loads in an environment of flat or declining
their optionality and extend their equity runway. Common solutions revenues. On top of this are looming maturity dates on LBO debt
being discussed range from credit agreement amendments to coming due in 2011-2014. The combination of these factors is expected
exchange offers, discounted debt buybacks, and pre-packaged to result in continued pressure to restructure existing debt through
bankruptcies. With over $125 billion of loans maturing each quarter this period. In addition, the return of robust equity markets is likely to
in 2010, these trends could continue for quite some time. spawn a new round of IPO financings for well positioned companies.
BMO Capital Markets Akin Gump Strauss Hauer & Feld LLP
For investments made in the previous 12 months, what When making investments in the previous 12 months,
percentage of the purchase price was funded with what percentage of the purchase price was comprised of
third-party debt? earn-outs or seller financing?
27% 1%-25% 58% 1%-25%
26%-50% 26%-50%
1%
14%
51%-75% 51%-75%
>75% No earn-outs or
seller financing
No debt was used 22% were included
over this time over this time
1%
32%
26% 19%
In the past year, 32% of respondents funded one quarter to one half Most respondents (58%) say investments made over the past year
of the purchase price of their investments with third-party debt. 46% typically incorporated seller financing or earn-outs worth up to
of respondents expect to fund the same portion of the purchase price one quarter of the total purchase price, while an additional 19%
with third-party debt in the year upcoming. of respondents say seller financing or earn-outs represented
between roughly one quarter to one half of the purchase price.
Again, although the proportion of third-party debt funding has
22% of respondents did not use seller financing over this time.
remained relatively steady, deal values have decreased for many
respondents who cite firms’ movement away from the large-cap
range and into the mid-market range, where financing difficulties
are less likely to hinder deal flow.
While earn-outs can prove to be an effective bridge between price

expectations of buyers and sellers, they do bring the risk of post-
closing disputes, particularly if they are poorly structured. This
can be quite problematic for sponsors if the beneficiaries of the
earn-out include the management team running the day-to-day
business. The successful earn-out is predicated on a clear business
understanding between the parties, particularly in the event of
contingencies such as acquisitions and dispositions; changes in the
business necessitated by economic conditions and changes in the
management team.
How does this percentage compare to previous years When you have used post-closing price adjustments for
(2007 or earlier)? existing investments, what are they typically based on?
60 56%
17% Lower
Higher 49%
50
Significantly higher
24% No change
40
33%
30
20
15%
11%
10
6%
53%
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53% of respondents say seller financing or earn-outs account for Working capital and earnings are the two most prominent bases
the same portion of the purchase price on current investments for post-closing price adjustments, according to 56% and 49%
as compared to 2007 or earlier. But aside from this majority, of respondents, respectively. Cash flow is cited by a third of
respondents are largely divided: approximately one third say this respondents as the most common determining factor for post-
percentage has increased since 2007 or earlier, but 17% say the closing price adjustments.
percentage has decreased over this time.
More respondents say seller financing and earn-out values have

increased rather than decreased, and this could be attributed in
part to investors’ concerns over keeping healthy companies on
track. In a climate where distressed companies seem to outnumber
healthy ones, one respondent stresses the importance of keeping
companies focused on continued growth by using earn-outs to
“motivate” management teams.
Seller financing is potentially a cheaper financing source for The prevalence of working capital adjustments reflects the fact that
buyers when compared to the costs of second lien or mezzanine working capital (usually) takes into account the other categories
financing sometimes used in leveraged transactions. Interest rates listed above, at least on a ‘current’ basis.
are typically lower and often accrue without cash payment until Akin Gump Strauss Hauer & Feld LLP
final maturity. Plus there is no commitment or underwriting fee
associated with seller financing.
Which of the following do you expect to be the primary What do you typically base earn-outs on?
purpose for earn-outs in the next 12 months?
100
54% To bridge the gap between
6% 90%
buyer and seller expectations
90
To incentivize management
80
To reduce the initial equity/
cash payment 70
60
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20 14%
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The majority of respondents (54%) expects to use earn-outs An overwhelming 90% of respondents say they typically base earn-
primarily to bridge the gap between buyer and seller expectations. outs on EBITDA, followed by less than a quarter each who base
Indeed, many respondents point out that economic uncertainty earn-outs on sales targets and revenue targets. Profitability of
has created an unfavorable valuation climate for many sellers certain product or service offerings and R&D benchmarks are least
as they are often dissatisfied with buyers’ low valuations. Fewer likely to be used as a basis for earn-out values for respondents,
respondents (40%) will use earn-outs to incentivize management, however, an executive draws attention to the fact that these particular
which one respondent says is what earn-outs have traditionally benchmarks tend to vary in importance according to the dynamics of
been used for in his experience. Interestingly, very few respondents a given industry. Companies in the Technology and Pharmaceutical
expect financing concerns to affect their usage of earn-outs: only industries, for example, tend to rely more heavily on R&D and product
6% expect earn-outs to be used to reduce the initial equity or cash development than other companies.
portion of a purchase price.
Earn-outs provide several benefits to buyers. Buyers can use When using EBITDA as an earn-out measure, the sellers will
earn-outs to trump competing offers in a competitive sales process, typically want to make additional adjustments to eliminate the
reduce a buyer’s initial cash consideration and motivate and retain impact of the deal on normalized earnings. These might include
management by aligning buyer and seller interests post-closing. adjustments backing out management fees paid to the sponsor,
But the risks of post-closing disputes posed by earn-outs should be accounting changes, non-cash compensation costs resulting from
carefully considered since disputes with in-place management can equity based incentive programs, financing costs (including costs
be disruptive to the post-closing business. arising out of future restructurings of the balance sheet) and other
Akin Gump Strauss Hauer & Feld LLP costs outside of the core operations of the target.
In the next 12 months, do you plan to change your If so, which sector(s) do you plan to focus on?
sector focus?
80
4% Yes
96%
No 70 67% 67%
60
50
40
33% 33% 33% 33% 33%
30
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An astounding 96% of respondents do not expect to change their The Consumer and Technology industries are by far the most
sector focus this year. Several respondents representing the popular sectors for respondents who plan to change their sector
majority say their firm prefers to stick with its area of expertise, focus this year. Automotive, Financial Services, Healthcare,
although distressed opportunities in other sectors are becoming Industrials and Telecom are each identified by a third of respondents
increasingly attractive and causing both financial and strategic as the sector they will most likely shift to this year.
buyers to move beyond their traditional strategies.
The high percentage of respondents gravitating toward the
Consumer sector is due in part to the distressed opportunities this
sector is expected to present. Indeed, the industry has seen a fair
share of bankruptcy filings over the past year and this trend is one
that many respondents say will continue for at least one year.
Some analysts speculated that private equity firms might re-

think their sector focus in light of the current economic turmoil –
potentially targeting more counter-cyclical industries or those that
do not exhibit much cyclicality at all. This survey reveals what we are
seeing in the marketplace – that private equity has a commitment
to its LPs to maintain its core investment strategy even through
temporary changes in macroeconomic conditions.
BMO Capital Markets
In the next 12 months, which of the following alternative In the next 12 months, what do you expect to happen to the
financing methods do you expect to be most common? usage of buyer closing conditions?
50% Increase
50
44% Decrease
45
Remain the same
40
35
29%
30 27%
25
20
15
10 43%
5 7%
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The largest percentage of respondents (44%) expect seller paper Half of respondents expect to see an increase in the usage of buyer
to be the most common method of alternative financing in the closing conditions this year, and an additional 43% expect usage
upcoming year, while rollover equity and earn-outs were each of buyer closing conditions to remain at its current level. Many
chosen by over one quarter of respondents. Seller paper, for many respondents who expect usage levels to remain the same say their
respondents, is viewed as an increasingly attractive method of firm has already increased its use of buyer closing conditions in the
working around financing difficulties. Others believe seller paper past year.
will be used primarily to “drive up the total deal value or purchase
price.”
One executive is especially keen on using rollover equity in the year

ahead, as this form of seller financing is often highly effective in
terms of attracting financial buyers, while another emphasizes the
ongoing benefits of earn-outs as they tend to “enhance operational
performance over the long term.”
Which of the following buyer conditions to closing have you On a scale of 1 to 5, how often do you expect to include
used in the previous 12 months? the following buyer conditions to closing over the next 12
months? (where 1 = rarely and 5 = almost always)
80 4.4
4.29
71%
70
4.2
58%
60
54% 53%
4.0
50
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3.66 3.64 3.63
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Nearly three quarters of respondents (71%) have incorporated MAC MAC clauses, which over the past year have been the most heavily
clauses into buyer closing conditions over the past year, making this used closing condition by the large majority of respondents, are also
the most widely used closing condition among respondents during expected to be used more than other buyer conditions to closing in
this time. Many respondents acknowledge highly publicized lapsed the year ahead. Legal opinions are expected to be used moderately
transactions in which MAC clauses played a significant role — such as well.
as the buyout of Huntsman Corporation by private equity backed
Again, the emphasis on MAC clauses seems to stem from high
Hexion Specialty Chemicals, where MAC clauses were used to justify
profile lapsed transactions in which MAC clauses proved influential.
the buyer’s decision to abandon the deal — as a major force behind
One respondent expects his firm to spend more time “analyzing
their use of MAC clauses in recent months.
the specific conditions” in MAC clauses, while another agrees that
Other buyer closing conditions are common as well, such as drafting MAC clauses in general will require more diligence than
minimum revenues or EBITDA requirements, legal opinions and in previous years.
receipt of third party financing, which are all identified by more than
half of respondents as buyer conditions to closing used in the past
12 months.
Beginning with IBP v. Tyson Foods and reaffirmed in Hexion v. Conditioning the closing of a transaction on receipt of legal opinions
Huntsman, the Delaware courts have made MAC clauses very has, in our experience, been on the decline in recent years. This data
difficult to invoke as a closing condition to a merger. This may explain may indicate a reversal in this trend as market participants place a
why objective standards such as minimum revenues or EBITDA are greater emphasis on downside risk protection.
second on this list. Akin Gump Strauss Hauer & Feld LLP
On a scale of 1 to 5, how often do you expect the following In the previous 12 months, have you delayed any of your
issues to be included as an exception to MAC definitions planned portfolio investment exits?
when doing a deal? (where 1 = rarely and 5 = extremely often)
4.0
35% Yes
3.5 3.36 No
3.14 3.11 3.05
3.0
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Respondents expect changes in the performance of a target’s While the majority of respondents (65%) have not delayed any
industry to be the most heavily used exception to MAC definitions planned exits in the past year, there are still slightly more than a
in deals this year. Interestingly, this exception is viewed by many third who have, many of whom point out that this is a poor time to
respondents as a response to adverse industry conditions across bring companies to market as valuations are often unfavorable and
the board. Some respondents expect buyers to have a difficult time do not necessarily reflect a company’s true value or potential.
walking away from deals even with heavily detailed MAC clauses.
One respondent explains: “In the current climate, it is going to be
very difficult for buyers to argue that one industry is in worse shape
than another, or that industry conditions are volatile enough to
justify pulling out.”
As credit markets tightened, acquisition multiples have generally

declined precipitously (with the reduction of acceptable total
leverage). Private equity firms are delaying portfolio company exits
Because it is so difficult to prove that a MAC has occurred under and instead focusing on improving internal operating performance
Delaware law, buyers should negotiate bright-line objective and controls, and shoring up the balance sheet as they wait for the
standards - based on targets’ specific circumstances - for when a economy to recover. In this market, protracted sales may also offer
buyer can terminate a transaction. MAC clauses should be relied the benefit of an expanded buyer universe if the ultimate suitor is
upon only for unforeseen events and changes. also a private equity firm.
Akin Gump Strauss Hauer & Feld LLP BMO Capital Markets
If yes, for how long do you expect to delay any such exits? If yes, which of the following best describes your strategy
for the investments you will exit later than planned?
8% 3-6 months 42% Improving operational

8% performance
38% 6-12 months
Implementing new
More than 12 months cost-cutting measures
Growing through add-on

12% acquisitions
Focusing on reworking the

company’s capital structure
Selling off non-core assets/

carve-outs
15%
23%
54%
54% of respondents who are holding onto investments for longer than Of respondents who are holding onto investments for longer than
they had originally planned do not expect to exit these investments expected, 42% say they are focusing on improving operational
for at least one year, or possibly longer. A smaller but still significant performance, and approximately a quarter of respondents are
38% plan to exit these investments in six months to one year. focusing on cutting costs. These two strategies are most common
among respondents, however, other strategies are fairly popular as
Respondents tend to believe that exit strategies will be adjusted
well, such as growing through add-on acquisitions and reworking
depending on company specifics. Companies going public for the
a company’s capital structure.
first time, for example, will likely delay their debut as they wait for
the valuation climate to improve.
Any delay in a planned exit may require refinancing of existing

indebtedness. Taking advantage of any ‘windows’ in the debt markets
may prove beneficial in the long run.
If in the next 12 months you were to take one of your When do you expect valuation gaps between buyer and
portfolio companies to market, would you use a narrow seller expectations to narrow?
process (defined as less than 20 parties) or a broad auction?
1%
49% Narrow 10% H1 2009

8%
Broad H2 2009
44%
H1 2010
H2 2010
2011 or later
37%
51%
Respondents are divided when it comes to preferred auction Overall, 81% of respondents expect valuation gaps to narrow
processes for portfolio company auctions planned for the upcoming in 2010, with the slight majority (44%) of these respondents
year, with about half preferring broad auctions and half preferring forecasting the first half of that year. Only a small fraction of
narrow auctions. Shedding light on this split, respondents from respondents believe expectations have already leveled out in the
each side explain the benefits of both: one respondent says narrow first half of 2009, while roughly one tenth believe this occurred in
auctions allow his firm to “focus on the target buyer universe”, while the second half 2009. Approximately one tenth of respondents are
a respondent who prefers broad auctions says working with a higher less optimistic about the valuation climate going forward, predicting
number of bidders typically results in a higher purchase price. that the gap between buyer and seller expectations will not narrow
until 2011 or later.
The decision to go broad or narrow is highly dependent on the deal, Buyers should consider using earn-outs and rollover equity as
and less so on the current economic conditions – more a function potential solutions for bridging valuation gaps between buyers
of the seller’s competing objectives to maintain the confidentiality and sellers. Earn-outs and rollover equity require lower up front
of the process and to maximize the auction tension. To try and take cash consideration from buyers and motivate sellers to continue
advantage of both, in recent deals, certain private equity firms have to actively grow the target business to increase their payday from
performed ‘fireside chats’ to test the market with top tier buyers future events.
prior to launching a full-scale process. Akin Gump Strauss Hauer & Feld LLP
BMO Capital Markets
In your opinion, what impact do you think the new When do you expect the financing markets to improve?
administration will have on transactional activity in the
next 12 months?
80 75%
4% H2 2009
22%
70 H1 2010
13%
H2 2010
60
2011 or later
50
42%
40
61%
30 26%
20
10
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75% of respondents expect to see increased regulatory oversight Respondents are relatively optimistic about financing conditions
over transactional activity in the year ahead. In addition to this, in the years ahead. 61% of respondents expect the markets to
42% of respondents expect the government to influence sector improve in the second half of 2010, while nearly one quarter of
specific transactional activity by offering economic incentives, and respondents expect to see improvements in the first half of that
approximately one quarter of respondents believes the government year. Most of the remaining respondents (13%) do not expect to see
will directly participate in transactional activity. improvements to the financing markets until 2011 or later and only
a small fraction of respondents believe financing conditions have
already improved in the second half of 2009.
The Obama administration’s impact on deal activity will certainly vary

by industry. For example, implementation of a cap and trade system
for carbon emissions is expected to increase investment attention to
businesses involved in ‘green’ technology, while uncertainty about
the results of healthcare services legislation could push investor
capital to other sectors.
The Purchase Price

Earn-Out: Potential
Fuel for Dealmaking
by David J. D’Urso, Partner, Akin Gump Strauss Hauer & Feld LLP
Despite the sustained economic downturn and significant The successful earn-out must be structured on methodologies
decline in private equity M&A activity, deals are still closing. and criteria that align purchaser and seller expectations and
Certainly dealmaking is not what it once was in more liquid motivations. At the onset of deal negotiations, it is critical that
periods, and transaction amounts, in addition to deal volume, purchaser, seller and their respective advisors engage in a
are considerably smaller in size. Distressed acquisitions, special forthright dialogue regarding how to define earn-out milestones,
situation investments and loan-to-own transactions are currently payments and governance of the business during the earn-out
comprising the bulk of M&A activity for private equity investors. Not period. Earn-outs are typically based on EBITDA, as evidenced by
surprisingly, deals are being structured overwhelmingly in favor the 90% of survey respondents who pointed to this method when
of the purchaser, resulting in a clear shift away from the “seller’s asked how they base earn-out payments. Purchasers tend to favor
market” of the past few years fueled by easy access to cheap capital. EBITDA targets as the most accurate depiction of the company’s
In fact, the majority of respondents to this poll maintained that financial health. Alternative methodologies for calculating
economic uncertainty has created a valuation climate that favors the benchmarks include sales and revenue targets, profitability of
purchaser. Additionally, increased equity contribution percentages specific products/services and R&D benchmarks.
due to tight credit markets have caused purchasers to offer lower
Sellers should not agree to an earn-out without accepting the
prices for targets. However, sellers categorically remain optimistic
risk that the purchase price paid on the closing date could be
about anticipated valuations for their assets when entering the
the sole consideration for a transaction. While the seller is given
marketplace despite fears of cashing-out out at the bottom of an
the opportunity to increase the amount of consideration payable
economic cycle.
upon their exit event by properly structuring an earn-out in their
With this dichotomy, dealmakers should look to purchase price acquisition agreement, they must realize that the payment of
earn-outs to help bridge the valuation gap between purchaser and any additional consideration is ultimately based on the future
seller expectations. If properly implemented, purchase price earn- performance of the target business and not within the four corners
outs - deferred consideration payable only upon the achievement of of any legal document.
predetermined milestones - can act as key drivers to consummate
Operational Control
transactions. While earn-outs add complexity, careful structuring of
A key component of earn-out provisions outlines how the target
an earn-out can ultimately guide a deal to closing and induce more
business will be managed during the earn-out period. While the
purchasers and sellers to get back into the market.
purchaser will have legal ownership of the target business after
Benchmarks and Milestones closing the acquisition, the seller often continues to be involved in
Earn-outs can bridge the gap between seller expectations and the day to day business operations during the earn-out period for
purchaser realities by allowing the purchaser to offer a higher both transition purposes and to insure the seller’s potential payday
top-line purchase price with a portion of the purchase price payable from achieving the earn-out milestones. Clearly, the seller has a
when and if the target business achieves enumerated milestones. direct economic interest in the performance of the target business
This entices the seller to accept lower initial consideration with the during the earn-out period and the seller should therefore negotiate
expectation of additional future payments. In addition, this insulates for some level of authority to manage and operate the business
the purchaser from potentially overpaying for assets in an economic during the earn-out period. The acquisition agreement should
environment where a “recovery” may or may not be in the near delineate parameters on how the business will be operated during
future. If the target business achieves the milestones during the the earn-out period either by reference to a business plan or more
earn-out period, the purchaser should be happy to pay the balance detailed operational covenants that address investment, personnel
of the purchase price since the target business should be more and integration decisions. Earn-outs work best and are most
valuable upon such achievement. enticing to sellers when the seller takes an active role in the post-
closing operation of the business.
Although the purchaser should directly benefit from the earn-out is treated as purchase price or compensation is whether
achievement of the earn-out milestones based on increased the earn-out is automatically triggered or forfeited upon the
valuations of the underlying business, the purchaser needs to termination of the seller’s employment with the business.
balance potentially short-sighted seller motivations to hit the
Additionally, purchasers should be mindful of recent FASB
earn-out benchmarks against the longer term health of the target
pronouncements implemented at the end of 2008 regarding
business. A careless purchaser runs the risk of granting too much
accounting for earn-outs payable in cash. The new rules require
control to the seller who may make business decisions based on
that future earn-out payments must be assigned a fair value at
the potential for maximizing earn-out payments. The Purchaser
the closing of the transaction and subsequently recalculated at
should be aware that Delaware courts have concluded that implied
each reporting date. Fluctuations in the changing value of the
covenants of good faith and fair dealing require purchasers to
earn-out can be problematic for purchasers who want to avoid
give the seller a fair opportunity to operate a target business in a
earnings swings. Purchasers also need to consider the quarterly
manner to maximize earn-out consideration. Therefore, checks and
recalculation effect on their loan agreements and the impact that
balances are appropriate and earn-outs work best when they apply
earn-out obligations may have on compliance with any financial
to shorter periods – 12 to 24 months – at which point, the purchaser
covenants included in such agreements. C
will need unregulated control of the business to execute on its

Bridging the Valuation Gap
M
strategic objectives.
Y
In the uncertain economic environment which seems to have
Since courts often have difficulty determining appropriate damages
conflicting reports about varied alphabetical shaped economic CM
in litigation involving earn-outs, the seller should require earn-

recoveries at every flip of the financial papers, both purchasers and MY
out provisions to specifically address the issue of damages in the
sellers are approaching dealmaking cautiously. Purchasers are
event disputes arise under the business governance mechanics. CY
concerned about overpaying for targets and sellers are faced with
Liquidated damages - fixed damages agreed upon by the parties CMY
diminished negotiating power, particularly when a seller may be

in advance as payable in specific circumstances - are useful where K
frantically eying exit strategies for a distressed company. In this

proving actual damages may be difficult if the purchaser fails to
market, earn-outs can entice sellers to consummate transactions
operate the business in accordance with negotiated covenants
in situations where the initial offered consideration does not equal
included in the acquisition agreement. For example, a seller
their expectations. The potential for additional consideration
may request that the earn-out be paid in full notwithstanding the
upon the achievement of predetermined milestones improves the
achievement of the milestones if the seller’s employment with the
attractiveness of offers and both the purchaser and seller benefit if
target is terminated without cause or if the purchaser fails to make
the benchmarks are subsequently achieved.
capex in accordance with an agreed upon budget.
While including earn-outs as a component of the purchase price
Tax and Accounting Considerations
can add complexity to the dealmaking, earn-outs have the potential
A properly structured earn-out requires the active involvement
to increase current deal activity by enticing purchasers and sellers
of tax and accounting advisors early in the process in order to
to bridge valuation gaps. Understanding the initial structural
insure that the parties’ agreed upon objectives are not undermined
considerations and pitfalls of earn-outs can facilitate negotiations
by tax or accounting issues. Unless the seller elects to opt out
and improve expectations and realizations for both purchasers and
of the “installment method”, the seller would generally get the
sellers in the dealmaking process.
benefit of tax deferral and recognize the deferred portion of the
consideration only when, and if, actually paid. Additionally, earn-
outs can be treated as purchase price thereby resulting in a general
treatment as capital gains to the seller and increased basis for the
purchaser. In certain circumstances, earn-outs could be treated
as compensation for employment services resulting in the opposite
effect – ordinary income to the seller and an expense deduction for
the purchaser. One of the key factors in determining whether an
© 2009 Akin Gump Strauss Hauer & Feld LLP. Attorney Advertising.
Finding the Right Piece
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akingump.com | 13 offices worldwide | over 800 lawyers

Perspectives from an
Investment Banker Scott Humphrey,
Executive Managing
Director, Head of U.S.
Mergers & Acquisitions,
BMO Capital Markets
As we draw towards the close of a very challenging 2009, the results question, many of those surveyed believe there may be another
of this study could not be more timely. With the Dow and S&P up year or two left in restructuring mode. We believe this trend is
almost 50% from the market’s March 9th lows, investors in both unlikely to abate in the near-term but instead may actually
public and private equity are poised to deploy capital for fear that extend another 2-3 years.
they will miss the next swing to the upside. While some private
equity professionals surveyed believe the market run-up may be Of the deals getting done – or hoping to get done – greater
short-lived, they see plentiful opportunities to deploy capital. Certain emphasis will be placed on the right structure.
findings won’t strike the reader as surprising yet others may.
This survey was conducted in the summer of 2009 and was Related to the first point, private equity investors’ outlook for debt
focused exclusively on middle-market private equity firms, with capital to support outright acquisitions is tepid, at best. According
an average fund size of approximately $1.5 billion. Some of the to the survey, roughly two-thirds (2/3) of those surveyed believe that
key findings include: debt will account for less than fifty percent (50%) of the funding for
new deals. As private equity investors seek to deploy capital against
Private equity investors expect less “L” in the LBO. this new credit outlook, new transactions will likely depend on a
greater mix of consideration in the form of seller financing and/or
The well-known and well-publicized credit crunch is still working performance-based earn-outs. Of the financings being completed,
its way through the deal economy. Certain traditional mid-market private equity investors appear particularly sensitive to prepayment
financing sources are no longer in existence while other lenders’ penalties in this new credit environment and, in some instances, are
appetite for new leveraged credit is viewed to be tepid, at best. willing to fully finance the purchase price and “wait out” the drought
With this backdrop, sponsors have been looking at creative in the credit markets and re-finance when the clouds part.
investment strategies, such as acquiring distressed assets in the
secondary market – either as a yield investment or as a method The credit backdrop and broader distractions in the
to ultimately develop a controlling stake in the target company marketplace have delayed private equity exits.
following restructuring. Additionally, sponsors are increasingly
active in 363 sale processes, PIPEs and mezzanine capital with Much more attention is being paid to fixing the challenged
equity-like characteristics. companies in the portfolio while trying not to impede the future
value drivers for the healthy companies in the portfolio. For those
Private equity investors have kept their hands in companies that could pursue an exit in this environment, the lion’s
their pockets and focused largely on their existing share of private equity investors indicate they have delayed such
portfolio companies. plans for twelve months or more as they continue to optimize
performance characteristics while also “waiting out” the broader
A significant percentage of those surveyed indicated that they M&A market malaise. A small percentage (15%) indicated they
were not spending a lot of time in the past 12 months seeking would delay an exit for purposes of pursuing growth via additional
new investments or add-on acquisitions for portfolio companies. acquisitions. In reviewing their outlook for a recovery in the exit
Subsequent discussions reveal that many of the portfolio companies market, private equity investors were almost evenly split between
acquired in the past 2-3 years may – surprise, surprise – require a recovery being encountered in the first versus the second half
some degree of restructuring. Indeed, sixteen percent (16%) have of 2010, while a small group believed the recovery would extend
already restructured one or more of their portfolio companies and beyond 2010.
only fifteen percent (15%) believe they will most likely not require
restructuring of one or more of their portfolio companies. While the
outlook is highly dependent on the nature of the portfolio company in
Despite the vast sums of committed yet uninvested private In the past year and a half, the global financial markets have truly
equity capital available, private equity return expectations entered uncharted territory. As credit markets collapsed, purchase
have barely budged. multiples were dramatically impacted. Not surprisingly, as a direct
result, the appetite for planned portfolio company exits weakened
Of the investors surveyed, seventy-six percent (76%) indicated that – especially considering that IRR expectations for private equity
their return expectations were equal to or higher than prior year firms remained largely unchanged. On the buy-side, private equity
expectations. The majority of private equity investors are still pricing firms had to re-assess their ultimate capital structure for deals, in
mid-20 to low-30 percent returns while roughly fifteen percent (15%) many cases temporarily “over-equitizing” acquisitions. This survey
indicated they would deploy capital for targeted IRRs of less than intends to shed some light on these and other impacts of the current
twenty percent (20%). Some might argue that as broader market market turmoil, specifically as they relate to current and future
return expectations in the medium-term are heading ever-lower, private equity investments. We hope you enjoy the findings of the
alternative asset classes such as private equity would follow. survey – we certainly learned a lot in the process and look forward to
The survey indicates that virtually nothing has changed in pricing future opportunities to refine the analysis and commentary. We are
of private equity returns which either indicates higher levels of grateful to our colleagues at Akin Gump and mergermarket for their
perceived risk in these transactions or that the asset class is supportive efforts in developing, compiling and analyzing this survey.
seeking to post extraordinary spreads (alpha) to their traditional
investment benchmarks.
Lastly, private equity investors expect that the new

administration will have some impact on transaction
activity in coming years.
A vast majority of those surveyed indicated that they expect

increased regulatory scrutiny over future transactions while many
others expect certain sectors to continue receiving some form of
economic incentive to drive transaction activity.
With over 190 years of experience,

we’re used to hearing the words
DONE
DEAL Getting deals done in a difficult economy
takes both ambition and a skilled advisor.
www.bmocm.com
BMO Capital Markets is a trade name used by BMO Financial Group for the wholesale banking businesses of Bank of Montreal, Harris N.A. and BMO Ireland Plc, and the institutional broker dealer businesses
of BMO Nesbitt Burns Inc. (Member CIPF) in Canada, Europe and Asia, BMO Nesbitt Burns Ltée/Ltd. (Member CIPF) in Canada, BMO Capital Markets Corp., BMO Nesbitt Burns Trading Corp. and BMO Nesbitt
Burns Securities Limited in the U.S., and BMO Capital Markets Limited in Europe and Australia.
®
Registered trademark of Bank of Montreal in the United States, Canada and elsewhere.
TM
Trademark Bank of Montreal
M&A Advisory
Portfolio Company of Portfolio Company of
Sale to Sale by Gillett Family to a Sale to Merger with

TA Associates Consortium Led By Hicks Acquisition Co. International Assets
Geoff, Andrew and Justin Molson Holding Corporation
Financial Advisor Financial Advisor Financial Advisor Financial Advisor

Pending Pending September 2009 September 2009
Division of
Sale to Acquisition of Acquisition of

Chicago Growth Partners, Remaining Interest in the Certicom
Prairie Capital and Boddington Project
Sale to
TwinBridge Capital Partners
Cosmo Films Ltd.

July 2009 June 2009 June 2009 March 2009
Subsidiary of Porfolio Company of Porfolio Company of

Rosen’s Diversified, Inc.
Acquisition of Sale to Sale to Acquisition of

Instorage REIT CHS, Inc. DeVry Inc. Unipac
a Division of ITW

March 2009 January 2009 September 2008 August 2008
Leveraged Finance
Senior Secured Credit Facilities Senior Secured Credit Facilities Senior Secured Credit Facilities Senior Unsecured Term Loan
for Portfolio Company of for Portfolio Company of for Portfolio Company of
Chicago Growth Partners,
Prairie Capital and
TwinBridge Capital Partners
Lead Arranger & Co-Lead Arranger & Co-Lead Arranger & Lead Arranger &
Administrative Agent Co-Syndication Agent Administrative Agent Administrative Agent
July 2009 July 2009 June 2009 May 2009
BMO CAPITAL MARKETS

AT A GLANCE
BMO Capital Markets is a leading, full-service North American financial services

provider offering corporate, institutional and government clients access to a complete
range of products and services. These include equity and debt underwriting,
corporate lending and project financing, merger and acquisitions advisory services,
merchant banking, securitization, treasury management, market risk management,
debt and equity research and institutional sales and trading. With over 2,400
professionals in offices in 27 locations around the world, including 14 in North
America, BMO Capital Markets works proactively with clients to provide innovative
and integrated financial solutions.
BMO Capital Markets is a member of BMO Financial Group (NYSE, TSX: BMO),
one of the largest diversified financial services providers in North America with
US$385 billion total assets and 37,000 employees as at July 31, 2009.
ABOUT BMO CAPITAL MARKETS MERGERS AND ACQUISITIONS
BMO Capital Markets has a top-tier North American M&A practice, which has
extensive experience in public and private company transactions ranging from
friendly acquisitions to hostile takeovers. With the agility of a boutique firm and
the resources of a large financial institution, BMO Capital Markets can help your
company reach its most ambitious goals. Our firm has longstanding relationships
across North America. With over 50 M&A professionals in the U.S. and Canada,
BMO Capital markets has proven capabilities in buy- and sell-side transactions,
restructurings, recapitalizations and strategic reviews with both the strategic and
financial sponsor communities.
FOR MORE INFORMATION ON OUR PRACTICE, PLEASE CONTACT:
Andre Hidi Scott Humphrey Daniel Barclay

Executive Managing Director Executive Managing Director Managing Director
Head of Global Head of U.S. Head of Canadian
Mergers & Acquisitions Mergers & Acquisitions Mergers & Acquisitions
andre.hidi@bmo.com scott.humphrey@bmo.com daniel.barclay@bmo.com
(416) 359-4744 (312) 461-7672 (416) 359-4754
Historical Data
US and Canadian buyouts and exits by Volume US and Canadian Buyouts and Exits by Value
300 250,000
Buyouts Buyouts
Exits Exits
250
200,000
200
150,000
150
100,000
100
50,000
50
0 0
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3
04 04 04 04 05 05 05 05 06 06 06 06 07 07 07 07 08 08 08 08 09 09 09 04 04 04 04 05 05 05 05 06 06 06 06 07 07 07 07 08 08 08 08 09 09 09
The first three quarters of 2009 have generated 297 buyouts and 197 Aggregate buyout value in the first three quarters of 2009 totals
exits in the US and Canada, compared to 601 buyouts and 354 exits $30.3bn, representing a 57% drop from an aggregate buyout value
in the first three quarters of 2008. This represents a 51% decrease in of $70.8bn in the first three quarters of 2008. Aggregate exit value
the volume of buyouts and a 44% drop in the volume of exits. in the first three quarters of 2009 totals $12.9bn, representing a
decrease of 85% from an aggregate exit value of $84.4bn in the first
three quarters of 2008.
About mergermarket
mergermarket is an unparalleled, independent Mergers &

Acquisitions (M&A) proprietary intelligence tool. Unlike any other
service of its kind, mergermarket provides a complete overview of
the M&A market by offering both a forward-looking intelligence
database and an historical deals database, achieving real revenues
for mergermarket clients.
Any queries regarding this publication or Remark, the market

research, publications and events division of mergermarket should
be directed to:
Kevin Hill
Publisher
646.378.3181
kevin.hill@mergermarket.com
Remark, Part of The Mergermarket Group
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2nd fl. London, WC2R 0RL Grand Millennium Plaza
New York, NY 10011 United Kingdom 181 Queen’s Road, Central
USA Hong Kong
t: +1 212 686-5606 t: +44 (0)20 7059 6100 t: +852 2158 9700

f: +1 212 686-2664 f: +44 (0)20 7059 6101 f: +852 2158 9701
sales.us@mergermarket.com sales@mergermarket.com sales.asia@mergermarket.com
Disclaimer
This publication contains general information and is not intended to be comprehensive nor to provide financial, investment, legal, tax or other professional advice or
services. This publication is not a substitute for such professional advice or services, and it should not be acted on or relied upon or used as a basis for any investment
or other decision or action that may affect you or your business. Before taking any such decision you should consult a suitably qualified professional adviser. Whilst
reasonable effort has been made to ensure the accuracy of the information contained in this publication, this cannot be guaranteed and neither Mergermarket nor
any of its subsidiaries nor any affiliate thereof or other related entity shall have any liability to any person or entity which relies on the information contained in this
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Remark, the events and publications arm of The Mergermarket Group, offers a range
of publishing, research and events services that enable clients to enhance their own
profile, and to develop new business opportunities with their target audience.

FINAL REPORT - Private Equity Dynamic Conditions

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Private Equity Under Dynamic Market Conditions:

Portfolio Company Management & Key Deal Terms

The Purchase Price Earn-Out: Potential

Perspectives from an Investment Banker 20

Many respondents acknowledge a less favorable financing

61% Equal to previous targets 45% Less than 24%

We see our clients spending much more time on existing portfolio

22% Very likely 5% 21% 1%-25%

1% 16% Not likely 51%-75%

Will definitely not occur >75%

Already restructured or in the No debt will be used in the

27% 1%-25% 58% 1%-25%

While earn-outs can prove to be an effective bridge between price

More respondents say seller financing and earn-out values have

Some analysts speculated that private equity firms might re-

One executive is especially keen on using rollover equity in the year

As credit markets tightened, acquisition multiples have generally

8% 3-6 months 42% Improving operational

Growing through add-on

Focusing on reworking the

Selling off non-core assets/

Any delay in a planned exit may require refinancing of existing

49% Narrow 10% H1 2009

The Obama administration’s impact on deal activity will certainly vary

The Purchase Price

will need unregulated control of the business to execute on its

in litigation involving earn-outs, the seller should require earn-

diminished negotiating power, particularly when a seller may be

frantically eying exit strategies for a distressed company. In this

Our goal is your success. With a business-oriented approach to your issues, we

Kerry Berchem Ken Menges Frank Reddick

akingump.com | 13 offices worldwide | over 800 lawyers

Lastly, private equity investors expect that the new

A vast majority of those surveyed indicated that they expect

With over 190 years of experience,

Portfolio Company of Portfolio Company of

Sale to Sale by Gillett Family to a Sale to Merger with

Financial Advisor Financial Advisor Financial Advisor Financial Advisor

Sale to Acquisition of Acquisition of

Financial Advisor Financial Advisor Financial Advisor Financial Advisor

Subsidiary of Porfolio Company of Porfolio Company of

Acquisition of Sale to Sale to Acquisition of

Financial Advisor Financial Advisor Financial Advisor Financial Advisor

BMO CAPITAL MARKETS

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

ABOUT BMO CAPITAL MARKETS MERGERS AND ACQUISITIONS

FOR MORE INFORMATION ON OUR PRACTICE, PLEASE CONTACT:

Andre Hidi Scott Humphrey Daniel Barclay

mergermarket is an unparalleled, independent Mergers &

Any queries regarding this publication or Remark, the market

Remark, Part of The Mergermarket Group

t: +1 212 686-5606 t: +44 (0)20 7059 6100 t: +852 2158 9700

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