M&A AND CAPITAL MARKETS OUTLOOK SUMMER 2016

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1 M&A AND CAPITAL MARKETS OUTLOOK SUMMER 2016 Inside this Issue: M&A Market Overview M&A Market Activity Middle Market Deal Valuations Private Equity vs Strategic Valuations Middle Market Leveraged Buy Out Capitalizations Overall M&A Market Commentary In the early part of 2016, significant economic events including China s slowing economy, the energy market collapse and other global issues seriously affected business and consumer confidence. This led to dramatic swings in the equity markets and a continuation of the slowdown in M&A activity. During 2Q16 the deal community continued to process these 1Q16 issues and reacted to a number of additional significant events, including the rise of more protectionist trade policies in both the Democratic and Republican political parties, an unusual domestic political environment, the Brexit vote and the early season success of the Chicago Cubs. With the U.S. economy operating slightly above stall speed, the effects of these events has a greater impact than they would in a more robust growth environment. Slow economic growth and an uncertain global and domestic political environment continue to plague the M&A market. Middle market M&A activity extended its negative trend during 2Q16 with deal volumes declining to levels not experienced since the 2008 recession. Strategic buyers with large amounts of cash, and private equity funds ( PE ) with record amounts of investable capital are all anxious to engage in acquisition activity. There are plenty of qualified buyers but the sellers remain scarce. It seems that negative seller psychology remains an impediment to the commencement of many new sales processes. Uncertainty is caustic to the deal environment and so far 2016 has had a healthy dose of uncertainty. The outsized demand continues to sustain high company valuations making this an ideal market to consider liquidity options. Although trending higher United States GDP growth has remained muted since the recession, averaging about 1.75% compounded annual growth rate since the beginning of While 1Q16 GDP s final adjusted value of 1.1% was higher than the first GDP estimate provided in April, many economists are concerned that GDP growth around 2% has become the new normal. GDP growth rates have averaged 3.2% since 1948 and growth at the current subtwo levels are not sufficient to significantly improve individual and business conditions in the U.S. The Federal Reserve has used all the tools at its disposal, including very low interest rates, to stimulate the economy with little result. The idea that essentially zero interest Financial Markets Outlook Total U.S. Middle Market Loan Issuance Interest Rate Environment Middle Market Debt Multiples Transaction Highlight Prairie acts as exclusive financial advisor to Diedrich Drill, Inc. rates are, after seven and a half years, stimulating the economy strains credibility, says James Bullard, president of the Federal Reserve Bank of St. Louis in a recent interview. The outcome of the Brexit vote in the United Kingdom, other than the short term immediate market surprise to the size of the leave sentiment, so far seems to have had little effect on the global markets. The Brexit has already led to a strengthening U.S. dollar which will likely negatively impact U.S. exports in the long run. The Brexit vote highlights the risks in the global political environment. The general failure of the standard political policy answers in the current global environment have led to more protectionist trade and immigration rhetoric and the rise of alternative political leaders in a number of countries and the U.S. According to Goldman Sachs, political and institutional contagion is currently a significant business risk. On the bright side, the U.S. economy keeps chugging along at its 2% growth rate with some bright spots and cause for optimism. The ISM Manufacturing Index was up 1.9 to 53.2 in June, signaling strength in the manufacturing sector. The U.S. Consumer Confidence Index was 98 in June up 5.6 from its last measure pointing to consumers increasing confidence. The labor markets are close to full employment, with the unemployment rate at 2016 Prairie Capital Markets, LLC. All Rights Reserved

2 4.9%, although the labor participation rate remains stubbornly low at 62.7%. As of June 30, the S&P stock market index is up 4.1% and the Russell 1000 Index is up 4.0% since the beginning of the year. In addition, the Dow and the S&P equity indices set new records in early July. While the low interest rate environment has likely contributed to rising indices, the slight improvements in the economy might provide a little tailwind to the M&A market. Even with a slow economy, both strategic and financial buyers remain anxious to make acquisitions. While there is evidence that banks and other lenders are becoming more conservative, they still need to make new loans to grow their businesses. Low interest rates make the costs of acquisition debt capital very low. Low interest rates coupled with the unsatisfied demand for acquisition targets has kept business valuations at elevated levels. We encourage business owners to look at their transition goals and objectives. Now would be an excellent time to consider their strategic options and determine whether a company sale makes sense before the M&A market window closes. M&A Market Activity Middle market M&A activity continued to decline in 2Q16 producing deal activity levels and dollar volume that equaled the low points recorded after the recession ended in The trend in softening quarterly deal activity has been fairly pronounced over the last few quarters and is disconcerting to many in the M&A community. Continued global and domestic sub-par economic growth, global political uncertainty and more conservative lending parameters are all contributing to this negative trend in M&A activity. PE exit activity showed a similar story, where the number and dollar volume of deals exited or sold by PEs was down in 2Q16. Intense buyer competition for the low volume of good deals has served to sustain the high valuation levels for middle market companies with favorable characteristics. But the sustained attractive valuations do not seem to be inspiring a sufficient number of sellers to enter the market. While the M&A trend data is concerning, based on our M&A deal activity levels we believe that the lower middle market is starting to revive and we believe this may be a leading indicator for future growth in overall M&A activity. The $37 billion of middle market deals recorded in 2Q16 reflect a 23% reduction in dollar value from 1Q16. Furthermore, the 2Q16 dollar volume of deals was down 30% compared to the dollar levels experience in 2Q15. Year to date activity showed weakness as well with 1H16 recorded $85 billion of deals down 29% from the $119 billion recorded in 1H15. Similarly, the number of middle market deals recorded in 2Q16 declined 35% from the number of deals in 2Q15 and 27% lower than the number of deals in 1Q16. The average middle market deal size of $33.6 million in 2Q16 was up slightly from the average $31.2 million deal size closed in 2Q15. PE exit activity was down in 2Q16, with the number of exits decreasing about 6% from the 1Q16 exits and the capital exited down about 20% from 1Q16. Further declines from the last quarter is somewhat disconcerting. Middle Market Deal Valuations The lack of supply of new middle market deals has helped sustained the higher valuation levels in the M&A market. While PEs have abundant investable capital and strategic buyers continue to look at acquisitions to further their growth objectives, it appears as though these buyers are becoming more discerning at higher valuation levels. In spite of this new trend, we still believe this demand supply imbalance has likely added between 0.5x to 1.0x to middle market deal multiples. With the low levels of deal volume, the quarterly data comparisons are especially volatile and can move significantly from quarter to quarter. Therefore, in our opinion the 1Q16 data displayed does not portray accurate trend data for the first part of Sub-$25 million deal valuation multiples continued to drift upward settling at a 5.9x multiple for 2015 reflecting the deal 2 Prairie Capital Markets, LLC Quarterly Middle Market Perspective

3 supply/demand imbalance in middle market deal volume. Buyers continue to aggressively pursue deals across the middle market size spectrum. Valuations on the large end of the middle market ($50 to $100 million segment) declined in 2015 reflecting the increasingly evident effects of more conservative lenders in the larger deal market. Valuations in the $25 to $50 million segment moved a little higher in 2015 reaching the long run average valuation multiple for deals of this size. As we have suggested in our previous reports, properly prepared, solid performing companies are always welcome in the M&A market and will continue to receive strong buyer interest and premium valuations. Private Equity versus Strategic Valuations The market data and our recent deal experience suggests that strategic buyers are aggressive and active M&A market participants. In the low growth economy strategic buyers have limited organic growth opportunities and use acquisitions to increase revenues and meet earnings growth objectives. Strategic buyer acquisition synergies and more aggressive pursuit of acquisition targets has resulted in a trend of strategic buyers paying about 1.0x to 2.0x more that the PEs. While PE funds remain motivated to put capital to work, PEs are far more cautious at these higher valuation levels and more conservative in their acquisition offers. As a result, successful sellers in the M&A market are shifting from PEs toward strategic buyers. During 2015 and continuing into 2106, strategic buyers continued to bid on middle market acquisitions but slightly decreased the premium they pay over the PEs. PE acquisition multiples remained flat during 2015, closer to the long term averages for middle market PE deals. It is interesting to note that the PE valuations remain relatively static with the strategic buyer valuations ebbing and flowing from year to year. The supply demand imbalance continues in the middle market, although the quality of the average companies coming to market has declined somewhat. Well-prepared, attractive sellers can still take advantage of interest in M&A deals by both strategic buyers and PE funds and achieve reasonably high valuations. The data reflects valuation multiples for all size deals. Prairie Capital Advisors estimates that for middle market deals below $50 million, valuations are generally 1.0 to 2.0 multiples lower than the levels reflected in the table. Middle Market Leveraged Buy Out Capitalizations The amount of debt leverage employed in the Leveraged Buyout ( LBO ) market increased further in 1Q16. The amount of equity used in LBOs has declined to about 39% of the Total Capitalization through 1Q16. This increased debt leverage occurred even with the Business Development Companies ( BDCs ) becoming less of a factor in the leveraged markets. Many of the public BDCs are trading at less than their Net Asset Values making it difficult for them to raise new capital for lending activities. The mezzanine funds have welcomed this development and regained some of the deal market share they have lost over the last few years. Capital availability is not a limiting factor for deal activity in the current market, but more conservative lending parameters will likely to lead to future valuation issues. The use of debt has continued to increase during 2015 and into 2016 with total debt making up more than 60% of the typical LBO capital structure. The equity contribution in LBOs continues to decline, now representing 39% of the LBO capital structure, the lowest equity level since the 2008 recession. Large increases in the number of lending sources coupled with the greater sophistication of borrowers have all led to an increased use of debt capital in a typical LBO. The PEs use greater debt leverage to offset the effects that high valuations have on their expected investment returns. 3 Prairie Capital Markets, LLC Quarterly Middle Market Perspective

4 Banks and other debt sources are all competing aggressively for new opportunities leading to continued low capital costs. Deal structure and terms on the other hand are starting to tighten reflecting a more discerning lending community. The mezzanine funds continue to aggressively pursue deal opportunities. Competition from the BDCs has moderated so mezzanine funds are regaining their share of the deal flow. While interest only and payment in kind structures still dominate the markets, warrants have started to return to the mezzanine return structure. Mezzanine funds continue to pursue equity co-investment opportunities to improve their returns and increase their investment amount in deals. Overall Comment on the Financing Markets Loan growth continues to be very weak through the first half of Interest rates have been low for so long it has become the new normal. The new normal, low interest rate environment reduces the urgency to lock in current rates and borrow. With an economy growing at less than 2% annually it has become increasingly difficult to find compelling projects like plant expansion or plant improvements with strong enough returns to make borrowing necessary. Loan demand has been further affected by lackluster middle market M&A activity. There is evidence that more intense bank regulation is starting to cause higher loan costs and more conservative lending terms for the less than average credits. The continuing effects of these regulations are likely to filter through the lending markets and affect the M&A market in the future. For credit worthy companies with a need for long term debt capital this continues to be a borrowers market. The much anticipated Fed rate increase that occurred late last year has shifted the short end of the yield curve about 25 basis points higher. The recent Brexit situation and resulting uncertainty further shifted the long end of the yield curve lower reflecting the flight to safety effects of global investors moving into U.S. Treasuries. Continued Fed rate increases, should they occur later in 2016 and into 2017, will continue to shift the yield curve higher leading to higher future borrowing costs. The availability of debt capital is the central factor in supporting the current valuations in the M&A market. There is increased evidence senior lenders are becoming more conservative in making new loans. This trend should be carefully followed because any future decrease in debt availability will likely cause declines in M&A valuations. The prospect for further Fed interest rate increases in 2016 were dashed with continued slow economic growth and the potential Brexit induced economic shocks. Whereas the next Fed interest rate increase was expected early in the second half of 2016, now the earliest rate increase is expected in December 2016 or early in The continuously low interest rate environment continues to reduce the urgency to lock in rates with long term financing. Bank lenders continue to focus on relationship banking, corporate borrowers lines of credit and areas where they have a competitive advantage like operating business needs including payroll and checking accounts. Due to regulatory scrutiny, banks continue to be selective in making new loans and are very selective in new leverage transactions. The non-bank BDC lenders, due to their problems in attracting new funding, have reduced their participation in the leveraged loan market and have become more conservative in their lending practices. Interest Rate Environment At the end of 2Q16, one month and three month LIBOR were roughly 25 basis points higher than the rates at the end of 1Q15. This year over year increase in rates was largely due to the Fed rate increase late last year. The June 30, 2016 yields of the five year and 10 year U.S. Treasuries, the long end of the yield curve, are down 79 and 83 basis points respectively from the end of 2015, reflecting the flight to safety provided by U.S. Treasuries in the face of the slowing global economy and the Brexit uncertainty. Total U.S. Middle Market Loan Issuance Loan issuance continued to show softness in the first part of 2016 continuing a trend that started several years ago. Muted acquisition activity coupled with soft capital spending and slow economic growth all have reduced the need for additional borrowing. 4 Prairie Capital Markets, LLC Quarterly Middle Market Perspective

5 The unemployment rate stabilized slightly below 5% and the improving monthly new job numbers are positive signs in the slow growth economy. However wage growth and the labor participation rates still cause concerns and reflect economic softness. Low LIBOR base rates coupled with stable-to-narrowing lending spreads make this an attractive market for borrowers. Middle Market Debt Multiples Acquisition debt leverage levels have increased during the first part of 2016 reflecting more aggressive behavior of mezzanine lenders somewhat offset by more conservative senior lender behavior. The current average total leverage multiple of almost 4.1x is the highest leverage level since As stated earlier, the combination of senior and mezzanine debt providers are contributing more of the average deal s capital structure, helping to increase the overall leverage and reduce the amount of equity required in deals. The increased use of debt leverage helps sustain high middle market M&A valuations and enables PEs to compete with strategic buyers. Bank lenders continue to maintain credit discipline largely to satisfy their regulators. The regulators limit the amount of HLT ( Highly Leveraged Transactions ) exposure that a bank can hold. Bank provided senior credit facilities remain at the relatively conservative 3.0x EBITDA senior debt ratio so the slight decrease in the use of senior debt is likely due to less aggressive BDC lenders. Prairie Capital Advisors, Inc. is an employee owned company offering investment banking, ESOP advisory and valuation services to support the growth and ownership transition strategies of middle-market companies. Since 1996, we have led hundreds of sale, merger, acquisition, ESOP and financing transactions for our clients. All securities transactions are effected and offered through Prairie Capital Markets, LLC ( Prairie ), member FINRA/SIPC. This document is a result of Prairie Capital Market, LLC and is for informational purposes only. It is not intended as an offer or solicitation with respect to the sale or purchase of a security. The opinions expressed are the views of the writer and do not reflect the views and opinions of Prairie. Prairie shall not be liable for damages resulting from the use of or reliance upon the information presented herein. 5 Prairie Capital Markets, LLC Quarterly Middle Market Perspective

6 SELECT RECENT M&A TRANSACTION EXPERIENCE TRANSACTION HIGHLIGHT About Diedrich Drill, Inc. Founded in 1973 and located in LaPorte, IN, Diedrich is a manufacturer of Diedrich Drill brand drill rigs and tooling for the geotechnical, environmental, geothermal and groundwater drilling industries. The Company manufacturers a range of drill rig models that will typically reach depths from 25 to 2,000 feet. In addition, the Company manufactures a variety of tooling including augers, drill rods, soil samplers, among other tooling used in underground site investigation and monitoring activities. CONTACTS Terrel Bressler Managing Director tbressler@prairiecap.com Robert Auer Managing Director rauer@prairiecap.com Timothy Witt Managing Director tim.witt@prairiecap.com Anthony Dolan Director adolan@prairiecap.com Oakbrook Terrace One Mid America Plaza, Suite 1000 Oakbrook Terrace, IL Atlanta 3715 Northside Pkwy Bldg 200, Suite 675 Atlanta, GA Boston 225 Franklin Street, Suite 2600 Boston, MA Cedar Rapids nd Street SE Suite 1225 Cedar Rapids, IA Chicago 311 S. Wacker Drive Suite 2370 Chicago, IL Louisville 312 S. 4 th Street, Suite 700 Louisville, KY Philadelphia 100 N. 18 th Street Suite 300 Philadelphia, PA Prairie Capital Markets, LLC Quarterly Middle Market Perspective