ANTARES COMPASS: LEADING WITH OPTIMISM IN TIMES OF UNCERTAINTY How companies, sponsors and investors view the middle market landscape post-election. Optimism is the prevailing sentiment within the middle market following the 2016 election. By surveying our portfolio companies, sponsors and investors*, our conclusions provide greater depth into how players within the middle market are feeling. While uncertainty remains, concern and fear do not seem to be its root. Respondents appear to be conducting business as usual as they wait for the new administration to establish itself. Over the next 12 months, how confident are you in the U.S. economy? MIDDLE MARKET COMPANIES VERY CONFIDENT CONFIDENT UNCERTAIN PESSIMISTIC 8% 67% 2 2% PRIVATE EQUITY SPONSORS VERY CONFIDENT CONFIDENT UNCERTAIN PESSIMISTIC 71% 1 2% INVESTORS VERY CONFIDENT CONFIDENT UNCERTAIN PESSIMISTIC 67% 7% *See full survey methodology on page 3 2017 Antares Capital LP All Rights Reserved
MIDDLE MARKET COMPANIES Optimism: Middle market companies have set encouraging performance goals for the next 12 months. Over 8 of respondents expect to achieve moderate to strong year-over-year revenue growth 1. Bottom line goals show similar levels of optimism with three-quarters anticipating moderate to strong growth over the next year. Half of the respondents identified the primary drivers of organic growth to come from sales volume with new customers, expansion into new markets and launching new products or services. Internal optimism is supported by a favorable industry outlook. Nearly three-quarters of respondents foresee moderate to high growth within their respective industries. How do you project hiring will impact your workforce in 2017? A majority of companies expect to increase hiring in the next 12 months; nearly one-third plan to increase staff by more than 5%. Uncertainty: While respondents indicate that adding new customers and expanding into new markets will be the primary drivers of organic growth, two-thirds cite these as two of their biggest internal challenges for the year ahead. Hence, it is not surprising that a majority of companies look to M&A as their first use of excess cash flow. As a result, integrating add-on acquisitions is also expected to be a top internal challenge, along with hiring and acquiring talent and bringing a new product or service to market. Top five areas where middle market companies plan to spend any excess cash flow (ECF) in the next 12 months: ECF Spend Distributor Manufacturer Retail Service Provider Acquisitions 2 2 Capital Equipment Sales & Marketing 11% 27% 1 8% 1 11% IT 1 8% 1 11% SIZE TO REMAIN UNCHANGED DECREASE 1% 5% DECREASE >5% Hiring Employees 1 11% INCREASE >5% 4 INCREASE 1% 5% 32% 5% 1% Overall, responses suggest that operating companies are not pessimistic or even fearful following the election, but simply unsure of how they will be affected. 44% of respondents believe regulatory and policy changes will have an impact on their business in the next year, whereas 3 are uncertain. When asked which specific changes would affect them, health care reform and tax reform were the most common answers; minimum wage changes were flagged by companies touching the retail end market. The stronger U.S. dollar and trade conflict/import duties are areas of concern, especially for retail and manufacturing segments. 1 Moderate growth: 3 5%; Strong growth: >5% This information in this report is for informational purposes only, is current as of the date noted and should not be used or taken as finance, legal or other advice. The information presented should not be deemed as a recommendation to purchase or sell any securities or investments mentioned. Although Antares Capital LP believes that the information contained herein has been obtained from sources believed to be reliable, Antares Capital LP does not guarantee its accuracy and it may be incomplete or condensed. Nothing within this publication should be deemed to be a research report. Past performance is not indicative of future results. Q1 2017 1
PRIVATE EQUITY SPONSORS Optimism: Even more so than operating companies, 85% of middle market sponsors who responded are either confident or very confident in the U.S. economy this year. Only 2% of respondents are pessimistic. This dovetails into sponsors sentiment towards their portfolio activity, with 85% expecting the same, if not more, portfolio sales in 2017, largely driven by attractive exit valuations. The outlook for M&A activity may be encouraged by the fact that a majority of sponsor respondents have more than 5 of their current fund available to invest. Sponsors expect Business Services, Energy, TMT and Healthcare to experience the most growth over the next 12 months, while opinions on the remaining industry sectors were broadly dispersed. Which industries do you think will experience the most growth over the next 12 months? Business Services Energy Technology, Media and Telecom Healthcare Construction & Building Financial Services / Insurance Consumer Services Consumer Products Aerospace & Defense Food and Beverage Transportation Restaurants Uncertainty: Compared to the U.S. economy, sponsors have a more cautious view on the global economy. Two-thirds are either pessimistic or uncertain given the geopolitical risks and potential economic woes abroad. Additionally, Europe was cited as a particular concern, due to Brexit and upcoming elections. Sponsors do not anticipate the middle market M&A and LBO environment to shift dramatically compared to last year. Nearly three-quarters of respondents anticipate the same level of activity, tempered by inflated valuations. Hot market conditions have created a competitive environment, where sponsors are differentiating themselves by leveraging internal industry expertise, relationships with operating partners, or simply avoiding auctions altogether by seeking proprietary deals. Which strategies does your firm use to distinguish itself in an auction process? Internal industry expertise (past/current portfolio investments) Avoid auctions look for proprietary opportunities Leverage operating partners Pre-empt process with a commitment subject to no diligence outs Fund level revolvers, bid with all equity Valuation 28% 8% In addition, respondent comments suggest that sellers are waiting for clarity on tax reform, making this another example of the market s wait-and-see attitude. Chemicals, Plastics & Rubber Packaging Retail Capital Equipment Environmental Industries Automotive (OEM & Aftermarket) 2% 4% 8% 1 Q1 2017 2
INVESTORS Optimism: There are many areas in which investors feel optimistic, beginning with 7 confidence in the U.S. economy and only 4% anticipating a recession in 2017. Almost three-quarters of respondents expect to raise funds this year and 84% believe fundraising activity will increase from 2016. A majority of investors who responded believe leveraged loan volume will increase this year, with leveraged loan default rates to remain low. In the next 12 months, you expect U.S. leveraged loan volume to compared to the last 12 months. Increase by >1 Increase by <1 Stay flat (0<) Decline by <1 Over the next 12 months, you expect M&A / LBO activity to: Increase Stay near current levels Decrease 7% 47% 32% 48% 45% 7% While all respondents believe 3-month LIBOR rates will increase by December, 9 do not see them surpassing 2.. In a rising interest rate environment, sponsors are focused on implementing hedging strategies across their portfolios. More than half plan to hedge with caps and one-third will do so with swaps. Other points of optimism include expected increases in M&A and LBO activity. Roughly two-thirds of investors who responded also believe leveraged loans will outperform U.S. investment grade corporate debt. Even with a new administration in the White House, more than half of investors believe they will be positively affected by post-election regulatory and policy changes, including tax reform. Uncertainty: Conversely, investors view current middle market sponsored total debt to multiples as high or very high, with less than one-quarter of respondents believing they are reasonable. With leverage levels increasing, valuations naturally rise in frothy markets. Regardless of these valuation levels, and that a majority of investors expect middle market yields to remain flat, optimism prevails as investors intend to remain active in the market for the foreseeable future. SURVEY METHODOLOGY This edition of Antares Compass features information collected from 226 respondents: 90 middle market companies, 63 private equity sponsors and 73 investors. Surveys were sent to borrowers and private equity sponsors on December 13, 2016 and were finalized on January 3, 2017. The investor survey was sent on December 19, 2016 and was finalized on January 17, 2017. Middle Market Companies: 9 have $15MM $50MM of Utilize one of the following business models: distributor, manufacturer, retail or service provider Span 18 different industries and 21 end markets Private Equity Sponsors: 8 with a current fund size >$350MM; 54% with a fund size >$1B 51% with AUM between $1B $5B Investors: Identified as one of the following institution/investor types: bank, BDC, CLO, insurance, non-bank lender or other fund Statistical Significance: 95% confidence intervals for the population of survey recipients: Middle Market Companies: margin of error Sponsors: 1 margin of error Investors: margin of error Upon completing our survey, respondents could choose a charity to which Antares would donate $100. TOTAL AMOUNT RAISED $11,900 $5,300 $4,400 $21,600 Q1 2017 3
ANTARES PORTFOLIO TRENDS The charts on the following pages provide a window on growth and margin trends by industry across one of the largest U.S. sponsored middle market portfolios in the business. The data across the segments shown covers more than 230 sample borrowers out of the 425+ total borrowers in our portfolio. Note, acquisition growth is generally included in portfolio trends. A note from our Chief Credit Officer Our core portfolio assets grew over 25% in 2016. We saw growth from new customers in areas like healthcare and software as well as high demand for new growth and acquisition capital from our existing borrowers. Our portfolio remains diverse and quality remains solid, with the few borrowers in our portfolio that have exposure to oil & gas having seen stabilization of late. Sales and growth has slowed broadly from 2014 levels but GDP growth and M&A activity appear poised to pick up in 2017. Margins have been relatively stable but could face pressure in some segments if raw material and wage inflation rise as generally expected. Tyler Lindblad PORTFOLIO INDUSTRY TRENDS (LTM) Growth (YOY) Business Services Margins 2 22% 1 1 Business Services unchanged from Moody s 32 definition Capital Industries 1 1 Capital Industries includes: Automobile; Capital Equipment; Chemicals Plastics & Rubber; Construction & Building and Containers; Packaging & Glass Note: based on Moody s industry classification. Q1 2017 4
Growth (YOY) Consumer Industries Margins 1 1 8% 4% 2% 1 Consumer Industries includes: Beverage, Food and Tobacco; Consumer goods: Durable; Consumer goods: Non-durable; Hotel, Gaming & Leisure; Services: Consumer Healthcare 35% 3 25% 1 1 1 5% 1 Healthcare unchanged from Moody s 32 definition of Healthcare & Pharmaceutical. Note that while owned by GE Capital, Antares was precluded from covering healthcare, so data shown is since the Antares sale to CPPIB in August 2015. Since that time, Antares has seen a rapid growth in its Healthcare portfolio. Media & Publishing 1Q13 3Q13 1Q14 3Q14 1Q15 3Q15 2Q16 4Q16 27% 2 25% 24% 2 22% 1 1 Media & Publishing includes: Advertising, Printing & Publishing; Broadcasting & Subscription; and Media: Diversified & Production Technology 24% 28% 27% 2 25% 24% 2 22% Technology includes: Aerospace & Defense; High Tech Industries; and Telecommunications Note: Based on Moody s industry classifications. This information in this report is for informational purposes only, is current as of the date noted and should not be used or taken as finance, legal or other advice. The information presented should not be deemed as a recommendation to purchase or sell any securities or investments mentioned. Although Antares Capital LP believes that the information contained herein has been obtained from sources believed to be reliable, Antares Capital LP does not guarantee its accuracy and it may be incomplete or condensed. Nothing within this publication should be deemed to be a research report. Past performance is not indicative of future results. Q1 2017 5
LEADING PRACTICES FOR PE FIRMS By Frank Fumai, Deloitte & Touche LLP ffumai@deloitte.com In a slower growth environment, firms will want to focus on growing profitability through restructuring and operational efficiencies as opposed to front office deal-making alone. To support this transition, we recommend in our report that managers consider the rising importance of three broad areas that relate to the growth and profitability of the private equity firm and its portfolio: the need to create robust internal controls and processes; a growing focus on value creation and operational excellence of portfolio companies; and the use of technology to enable tax transformation. In regard to internal controls, for example, transparency requirements by regulators and investors alike are creating the need for firms to take a closer look at how these controls are set up, documented, and communicated to members of the firm and its portfolio companies. Well-documented controls, coupled with a strong training program, are key to having operational issues appropriately handled, while preventing deal-makers from being distracted by them. Looking forward, while we anticipate private equity to remain attractive to investors based on its outperformance versus standard benchmarks, balancing a firm s objectives of funding growth and lowering costs may become a focal point of the new normal. Though initial outlays may be required to support technology, infrastructure, and operational improvements, private equity firms that actively prepare for the challenges of the shifting environment may be more effectively positioned. Deloitte s proprietary global model for private equity (B)* Moderate Scenario 2006 2010 2011 2015E** 2016E $694 $715 $852 $1,491 $889 $1,781 $1,161 $2,493 $1,256 $2,325 Private equity firms are also focusing on the following as part of their operational excellence initiatives: 2020E $1,578 $3,079 - Due diligence: A big part of investment success at a private equity firm relies upon upfront due diligence and continued monitoring of portfolio company investments. On the diligence side, emerging trends include performing more operational diligence by looking at key functional areas of a target company, and using data and analytics to understand and improve performance. - Portfolio approach: While focusing on the operations of an individual portfolio investment remains important, we are seeing private equity firms taking an overall portfolio approach: looking for leading practices or functional areas at their highest-performing portfolio companies, and sharing those experiences across the entire portfolio. These activities help lower the overall operational risk in the aggregate, while supporting value creation, and can get the company to a spot where the opportunity for success is higher. $1,000 Dry powder $3,000 $5,000 Unrealized value Sources: 2016 Preqin Ltd. / www.preqin.com (2006-1H15); Deloitte Center for Financial Services analysis (2H15E-2020E). *Data excludes venture capital. ** Unrealized value data was extrapolated to reach Deloitte s December 2015 estimate. As shown above, PE dry powder is forecast to continue to build, suggesting fuel for M&A but also an increasingly competitive market with pressure on return expectations. For Deloitte s full report, see: Private Equity Growth in Transition: Evolve to Meet Tomorrow s Challenge Q1 2017 6