Financing ESOP Transactions- Lenders Perspective

Financing ESOP Transactions- Lenders Perspective 2015 California/Western States Chapter Conference Denver, Colorado September 24, 2015 Kurt Mair SVP and Western Regional ESOP Director Wells Fargo & Co. Matt Dalany Managing Director Verit Advisors Kevin Trieber SVP & National ESOP Champion Bank of America Merrill Lynch

Points bps M&A Environment Themes Underlying M&A Activity Drivers Acquisition financing available at attractive terms Historically high corporate cash balances Relatively few organic growth opportunities Pressure to keep up with acquisitive competitors Increased activism catalyzing deals Improving Equity Markets and Historically Cheap Financing (1) U.S. GDP Forecast (2) 18,500 18,000 17,500 17,000 16,500 16,000 15,500 130 08/29/14 11/10/14 01/22/15 04/06/15 06/18/15 08/31/15 DJ Industrials Average (Left) BBB Corp. Spread (Right) S&P 500 Corporate Cash Balance (1)(3) 230 1.1% 1.8% Real GDP Growth (% SAAR) 4.5% 3.5% (2.1%) 4.6% 4.3% 2.1% 0.6% 3.7% Normalized Market Volatility (1) 2.8% 3.0% 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 Return of financial sponsors $6.0 5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 $2.4 $2.5 $2.2 $2.1 $2.0 $2.0 $3.0 $3.4 $3.0 $4.7 $4.4 $3.9 2004 2006 2008 2010 2012 2014 50 45 40 35 30 25 20 15 10 5 Yr. Avg: 24.9% 5 08/31/10 11/30/11 03/01/13 05/30/14 08/31/15 (1) FactSet as of August 31, 2015. (2) BofAML GDP estimates per BofAML Economic Research as of September 14, 2015. (3) Average per company in billions. 1

Transaction Value ($BN) M&A Market Update Middle Market Deal Activity Has Recovered From the 2009 Lows and is Expected to Increase Americas Middle Market M&A Volume (2006 2015 YTD) (1) $200.0 Quarterly M&A Volume Q3'13 Q2'15 YTD Transaction Value ($bn) $700.0 $100mm $250mm $500mm $750mm $250mm $500mm $750mm $1bn 150.0 100.0 50.0 0.0 $121 $99 $108 $103 $106 $94 $89 26 14 23 17 23 $76 27 24 17 23 26 20 19 18 14 35 38 28 38 37 35 15 23 25 27 24 22 26 25 32 29 21 25 Q3' 13 Q4' 13 Q1' 14 Q2' 14 Q3' 14 Q4' 14 Q1' 15 Q2' 15 S&P 500 2,400 600.0 2,200 500.0 400.0 300.0 200.0 100.0 0.0 $474 $414 100 78 113 91 141 156 104 105 $286 53 59 94 $348 $374 59 72 66 $419 $384 $354 83 62 86 89 91 $206 99 86 27 138 48 128 118 109 119 72 81 59 85 97 95 87 112 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015YTD $240 48 59 70 63 2,000 1,800 1,600 1,400 1,200 1,000 800 600 # Deals 1,287 1,419 937 695 1,070 1,176 1,195 1,105 1,339 745 Source: Dealogic Analytics as of August 31, 2015. Target or Acquiror in Americas. (1) Excludes TARP investments. 2

M&A Market Update Financial Sponsor Middle Market Buyside/LBO Volume Annual U.S. Middle Market LBO Volume Quarterly U.S. Middle Market LBO Volume ($ in billions) LBO Volume $70 % of Total U.S. M&A Volume 18% ($ in billions) LBO Volume $12.0 $60 $50 $53 $55 $59 $54 16% 14% $10.0 $8.8 $9.4 $8.7 $10.7 12% $8.0 $7.7 $40 10% $6.5 $6.7 $30 $20 $22 $27 $23 $25 $33 $23 8% 6% $6.0 $4.0 $3.2 $3.5 $5.8 $5.5 $4.0 $4.2 $5.8 $10 $12 4% 2% $2.0 $0 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 0% $0.0 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 2012 2012 2012 2012 2013 2013 2013 2013 2014 2014 2014 2014 2015 2015 Source: Dealogic as of August 31, 2015. Note: Data reflects LBOs with transaction values of less than $1 billion. 3

M&A Market Update Financing Markets Accessible for Middle Market LBOs LBO Purchase Price & Debt Multiples (1) LBO Average Equity Contributions (2) 12.0x 50.0% 45.6% 44.8% 45.6% 43.3% 10.0x 8.0x 6.0x 6.6x 2.9 7.0x 3.2 7.2x 2.9 8.4x 3.4 7.4x 3.3 9.2x 3.4 8.3x 3.8 6.6x 3.4 8.8x 8.4x 8.2x 7.9x 4.1 4.1 3.7 3.3 9.6x 9.8x 4.3 4.7 40.0% 30.0% 20.0% 40.8% 39.7% 40.2% 37.9% 35.4% 34.1% 32.1% 40.7% 41.2% 40.4% 4.0x 2.0x 3.7 3.8 4.3 5.0 4.1 5.8 4.5 3.2 4.3 4.5 4.6 4.7 5.3 5.1 10.0% 0.0x 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 YTD 2015 Debt Equity 0.0% 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 YTD 2015 Source: S&P LCD Middle Market Lending Review as of July 31, 2015. Note: Data reflects LBOs in which the target had EBITDA of $50 million or less. (1) Purchase price multiples exclude fees and expenses. (2) Contributed equity includes common equity, preferred stock and rollover equity, as well as holding company debt and seller note proceeds downstreamed to operating company as common equity. 4

Leveraged Loan Market Update Loan Market Conditions Loan Volume ($ Bn) $27.6 Sep-14 $46.7 $27.2 $24.6 Nov-14 $33.5 Jan-15 $21.5 Institutional YTD 2014 YTD 2015 Pro Rata $104.4 Bn $123.3 Bn Inst. $306.2 Bn $193.7 Bn Total $410.6 Bn $317.0 Bn $38.4 Mar-15 $47.8 $41.8 May-15 $49.9 Pro Rata $62.7 Jul-15 $14.5 $6.8 Sep-15 Leveraged Loan Yields 5.5% BB- B 5.0% 5.015% 4.5% 4.280% 4.0% 3.5% 3.0% Sep-14 Nov-14 Jan-15 Mar-15 May-15 Jul-15 Sep-15 Cov-Lite % of Inst. Volume 93% 84% 73% 69% 63% 68% 70% 71% 65% 55% 58% 45% 40% Sep-14 Jan-15 May-15 Sep-15 Mutual Fund Flows ($261) ($4) $163 $155 ($59) ($353) ($427) ($454) ($442) ($110) Visible Repayments ($ MM) ($ Bn) ($ Bn) YTD 2015: ($11,776) MM YTD 2014: ($4,120) MM $46 $41 $35 $21 $22 $33 $32 $31 $29 $27 $27 $27 $27 CLO Issuance $53 $97 $89 YTD 2015: $74.0 Bn YTD 2014: $87.5 Bn $53 $82 $124 $74 ($779) $14 $1 $3 $12 2-Jul 16-Jul 30-Jul 13-Aug 27-Aug 10-Sep 18-Jun 2-Jul 16-Jul 30-Jul 13-Aug 27-Aug 10-Sep 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 5

Leveraged Loan Market Update Leveraged Finance Snapshot Forward Calendar by Use of Proceeds ($ Bn) $70 60 $52.2 50 $45.3 $45.7 $41.3 $41.1 $39.6 $36.0 $37.4 40 $34.4 $34.7 $34.7 30 Institutional Buyers 2Q15 Loan Mutual Funds 20% CLO 65% 20 10 0 2-Jul 16-Jul 30-Jul 13-Aug 27-Aug 10-Sep Acquisition LBO Refinancing Dividend GCP Hedge, Distressed & HY Funds 8% Insurance Co. 5% Finance Co. 2% LIBOR Outlook YTD 2015 Returns by Asset Class 4% 3 Current 3Q15 4Q15 1Q16 2Q16 BofAML Research -- 0.53% 0.77% 1.05% 1.30% Forward Curve 0.28% 0.42% 0.62% 0.86% 1.12% (0.2%) 0.6% 2.3% 2 (2.5%) 1 (3.8%) 0 2015 2016 2017 2018 2019 2020 (6.7%) Gold IG Bonds HY Bonds Wilshire 5000 S&P 500 Lev Loans 6

Leveraged Loan Market Update Pro Rata Market Demand Strong credit quality of banks loan portfolios combined with ample liquidity and access to low-cost capital Strong Credit Quality of Loan Books 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% '91 Q2 '95 Q2 '99 Q2 '03 Q2 '07 Q2 '11 Q2 '15 Q2 (bps) Charge-Off Rate Delinquency Rate Continued Deposit Growth ($tn) 12 11 10 9 8 7 6 5 4 Jul-07 Jul-09 Jul-11 Jul-13 Jul-15 Tightening Bank CDS 190 170 CDS for Global Banks 150 130 110 96 bps 90 70 50 Sep-12 Mar-13 Sep-13 Mar-14 Sep-14 Mar-15 Aug-15 has fueled continued demand for loans, leading to easing credit standards and tightening credit spreads Easing Credit Standards Amidst a Stable Level of Supply Tightening Credit Spreads L+250 L+225 L+200 L+175 Source: Board of Governors of the Federal Reserve System, Bloomberg, S&P and BofAML. 60% 30% 0% (30%) (60%) (90%) Apr-06 ($bn) TLA REV $149 $68 $35 Easing Standards Tightening Standards % Reporting Stronger Demand $74 Apr-09 Apr-12 $145 $164 $142 $147 $38 Apr-15 Moving Average $54 2007 2008 2009 2010 2011 2012 2013 2014 1Q15 2Q15 L+150 Sep-12 Mar-13 Sep-13 Mar-14 Aug-14 Feb-15 Aug-15 What to Watch Impact of Basel III regulations on banking system, and implications on loan pricing, particularly undrawn fees Heightened regulatory focus on highly leveraged transactions Expectation for rising interest rates later this year 3-month LIBOR 10-yr US Treasury Q3 '15 Q4 '15 Q1 '16 Q2 '16 BofAML Research 0.53% 0.77% 1.05% 1.30% Forward Curve 0.42% 0.62% 0.86% 1.12% BofAML Research 2.25% 2.35% 2.50% 2.65% Forward Curve 2.26% 2.49% 2.62% 2.76% 7

The ESOP Option? It depends on your perspective Business Owner The ESOP is a buyer that provides tax-advantaged liquidity and diversification along with flexibility. Employees The ESOP is a company funded retirement plan that encourages employees to think like owners. Companies The ESOP provides tax advantages that aid in financing the ESOPs purchase. Banks The ESOP creates a financing opportunity to assist a good client or prospect carry out his or her Business Transition needs. 8

What is an ESOP? Qualified Plan 1. Contributions are tax deductible by the sponsoring company 2. Employees are not taxed on contributions 3. Income earned by the ESOP trust is not taxed 4. Invest primarily in employer securities 5. Can borrow Vehicle for Ownership Transition 9

Employees Shareholder Company S ESOP vs. C ESOP Tax Benefits S Corporation C Corporation ESOP income allocation is not subject to tax Tax deductions for contributions tax deductible up to 25% of eligible payroll 100% S no federal income tax Broad based ownership Terminate S election Long term S Corporate shareholders have high basis stock and smaller capital gain Installment sale treatment for gradual sales Contributions for principal and interest are tax deductible up to 25% of eligible payroll Dividends on ESOP stock are tax deductible Re-elect S Corporation after 5 tax years May defer the capital gains tax on sale to the ESOP (1042) Must reinvest proceeds Financial benefits of ownership typically without personal contribution Management incentives phantom stock, SARs, etc. Improved productivity gains due to employee owned culture DISCLAIMER - This is not intended to constitute tax advice. Please consult with your tax advisor for specific guidance 10

Current Trends and Topics with ESOPs Recent market activity shows companies are having more success with raising capital. Active capital providers consist of Banks and Non-Bank Lenders; many of which are looking for assets. Many Lenders that have been balance sheet focused in the past are willing to entertain cash flow structured facilities for good clients and prospects. Junior Capital providers traditionally working with $5MM + EBITDA Companies are now entertaining smaller transactions. HLT Guidelines When above a certain multiple, loans made with high leverage require reporting to the OCC. Sources: PE Hub, National Federation of Independent Business, Business Capital, and Office of the Comptroller of the Currency 11

Capital Sources Capital Providers include: Senior Debt Commercial Banks, Debt Funds, Finance Companies. Subordinated/Mezzanine Debt Debt Funds, SBIC Funds, Sellers rolling proceeds into post-sale capital structure Structured Equity Private Equity Funds, Sellers. Equity Private Equity Funds, Sellers rolling over equity/retaining stock in a Partial ESOP stock sale. General Pricing Bank Rates Libor Rate Spreads generally between 2 and 6 percent. Subject to change based on market conditions or company risk profiles. Mezzanine Typically, 10 to 14% all-in (cash-pay, PIK, Warrants). 12

What is an ESOP Basic Structure? Leveraged ESOP Transactions Structure The company (ESOP plan sponsor) creates an ESOP Trust. The company borrows funds ( Outside Loan ) and re-lends the proceeds ( Inside Loan ) to the ESOP Trust. The ESOP Trust uses the funds to purchase shares from the existing shareholders. The shares are held in the ESOP Trust with a contra-equity account established on the company s books for the value of stock purchased. The accounting method is very similar to Treasury Stock accounting. Leveraged ESOP Purchase of Existing Stock Company Inside Loan Outside Loan Lender Shareholder Stock Cash ESOP TRUST 13

Seller Debt = Subordinated Debt Typical structures in ESOP transactions Subordinated debt refers to debt that is contractually subordinated with respect to payment to other debt in an issuer s capital structure. Subordinated debt may also be used to refer to debt that is structurally subordinated to other debt in the capital structure (junior debt). Debt that by its terms is subordinated to all other debt Terms of subordination typically include: Payments of principal only after the senior is paid in full Payment blockages payment of interest is blocked if there is a senior default Standstills restrictions on remedies until the senior is paid in full Lien subordination unsecured (if liens are permitted they are junior) 14

The Four C s of Credit Basic lending guidelines Character Cash Flow Management history and depth Customer concentration Stability of industry (growth vs. mature) Stability of cash flow, future cash flow, projections Cash flow cushion Ability to meet covenants Collateral Collateral coverage Advance rats Time until fully collateralized Capital Other demands on capital Seller subordinated debt Access to other sources of capital 15

Potential ESOP Client Profile Company Dynamics: Stable performers with meaningful taxable income and free cash flow (usually $2MM in free cash flow and greater.). Businesses where employees are a key asset Specialized niche business where other third party buyers may be difficult to find. Strong Employee Culture and Closeness Unleveraged Firm if possible entering into the Transaction Minimal or Manageable Cap-ex needs Adequate Liquidity pre and post transaction for operational and growth needs 16

Potential ESOP Client Profile Ownership Situation: Business Owners seeing partial or full liquidity and looking for an alternative to a strategic sale, private equity or IPO Family owned business where some family members are seeking liquidity and others are not ready to exit Owners concerned about sharing confidential information Owners sensitive to income and capital gain taxes Owners wishing to retain governance in running their operations Owners with a strong appreciation for their employees 17

General Leverage Parameters Commercial Banks (Senior Debt): Up to 4 times EBITDA (or EBITDAE) with a preference for 3 times or less. May have adjustments post-close. Outside Mezzanine Debt (Secured or Unsecured) Between 4 and 6 times EBITDAE with most in the three to five times range (inclusive of senior debt) Seller Notes In excess of Senior or Senior and outside Mezzanine Financing. Note while characteristic of equity the OCC still includes seller financing in Total Debt computations. DISCLAIMER These leverage parameters are not fully representative of Wells Fargo s or Bank of America, N.A. s credit structures. Each loan and its respective covenants are customized based on the specific profile of the borrower. 18

Potential Financial Covenants Purpose of Financial Covenants to adequately monitor and protect the sources of repayment of a Bank s credit extension. Fixed Charge Coverage measures ability to adequately cover debt service requirements with free cash flow Senior/Total Leverage measures amount of debt relative to free cash flow Liquidity Ratios measures sufficiency and ability of short term assets or access to capital to pay short term obligations and liabilities Negative Covenants limitations or restriction on certain events that could impact risk profile DISCLAIMER The above are sample covenants that Wells Fargo and Bank of America, N.A. may incorporate into their lending agreements. 19

Transaction process and timeline After the decision has been made to proceed Days 0-45 45-90 90-130 130-180 Initial Interest Feasibility/Alternative Structures Advisory Teams Selected Secure Financing Negotiate with ESOP Trustee Due Diligence Documentation Initial Interest Learning period Gathers information Determines objectives Feasibility/Alternative Structures ESOP I-banker or financial advisor prepares feasibility Presents preliminary valuation Recommends structure Advisory Teams Selected Interview and retain ESOP advisors Company advisors prepares transaction description Secure Financing Prepare memorandum Initiate discussions with various capital providers Negotiate with ESOP Trustee Present transaction to trustee and trustees advisors Negotiate deal terms Due Diligence Manage due diligence with data room Documentation Coordinate legal documentation with all parties 20

Questions? 21