KeyBanc Capital Markets conducts a quarterly survey of junior debt participants to measure market conditions and transaction terms. In this newsletter, we share with you the results of the survey and provide other anecdotal observations to bring you our state-of-the-market perspective. Junior Debt Market Overview Executive Summary Q4 2015 saw a decidedly negative outlook creep in to the junior debt markets This negative outlook is consistent with the broader senior debt market, which has seen new issue volume drop precipitously in Q4 and in to Q1 2016 as well as significant declines in the secondary market Investors are looking at a lot of transactions but closing very few 67% of respondents reviewed more than 50 transactions while 62% closed two transactions or less A significant number of respondents expect leverage levels to decrease and covenant defaults to increase Pricing is widening Base case pricing (all-in IRR) migrated to 13%-1 - up about 100bps over prior quarters This is significant in that this is the first increase in pricing we have seen since Q1 2014 While we are not predicting the complete return of warrants / equity upside, more respondents are saying they are participating in the equity (most of which is through an equity co-investment) The second lien market is experiencing significant headwinds, leading to a higher cost of capital for borrowers Turbulence in the broader capital markets, including equity, senior debt, high yield and other credit markets, as well as dwindling BDC appetite for second lien paper are some of the key factors influencing second lien pricing Second lien pricing has migrated from ~1 to ~12% Capital available for lending remains abundant, with ~4 of junior debt funds having >$250 million KeyBanc Capital Markets Debt Capital Markets The KeyBanc Capital Markets Debt Capital Markets team represents one of the strongest full-service debt-side investment banking, sales, trading and distribution platforms in the nation. We use a blend of real world perspectives, backed by robust capabilities and relationships, to help our clients use leverage to grow, make acquisitions, and enhance operations. For additional information regarding KeyBanc Capital Markets or this newsletter, please contact the individual listed below: Andrew Frawley 216.689.4288 afrawley@key.com Meghan Curran 212.476.7465 meghan.curran@key.com Disclosure: KeyBanc Capital Markets is a trade name under which corporate and investment banking products and services of KeyCorp and its subsidiaries, KeyBanc Capital Markets Inc., Member NYSE/FINRA/SIPC, and KeyBank National Association ( KeyBank N.A. ), are marketed. Securities products and services are offered by KeyBanc Capital Markets Inc. and its licensed securities representatives, who may also be employees of KeyBank N.A. Banking products and services are offered by KeyBank N.A. This report was not issued by our research department. The information contained in this report has been obtained from sources deemed to be reliable but is not represented to be complete, and it should not be relied upon as such. This report does not purport to be a complete analysis of any security, issuer, or industry and is not an offer or a solicitation of an offer to buy or sell any securities. This report is prepared for general information purposes only and does not consider the specific investment objectives, financial situation and particular needs of any individual person or entity.
Overview of Funds Industry Breakdown Q4 2015 Q3 2015 Industrial Manufacturing Consumer Business Services Health Care Information Services Transportation and Logistic Basic Materials Education Professional, Scientific, and Finance and Insurance Energy and Utilities Technology Construction, Engineering Hospitality Real Estate Other Waste Management Do not have any industry s 4% 3 24% 24% 1 3 3 3 32% 2 12% 8% 48% 44% 1 1 13% 13% 9% 9% 9% 3% 3% 3% 38% 38% 59% Junior debt providers continue to consider a broad range of industries Most providers are generalists Current industries of note include business services, industrial manufacturing, health care, information services, and transportation and logistics Fund Profile Available Capital 4 3 29% 24% 2 19% 19% 1 1 <$50M $50M - $99M $100M - $250M $251M - $500M > $500M 6 Time Needed to Raise New Fund Typical Investment Size $11M - $25M 24% >$50M 5% <$5M 24% $5M - $10M 4 NTM New Fund Raise Significant capital remains available to issuers seeking junior debt; ~4 of the funds that responded have more than $250 million of available capital and 19% have more than $500 million available 5 4 3 2 1 13% 5 38% Undecided 25% No 35% Yes 4 63% of respondents feel a fund can be raised in 12 months or less <6 months 6-12 months 13-18 months 2
Junior Debt Deal Flow Screening (10/1/2015 12/31/2015) Portfolio Investment Sources Sponsored vs. Non-Sponsored Deals Other Investment Banks 2 Non-Sponsored 47% Sponsored 53% Other Mezzanine Funds PE Sponsor Groups 41% Transactions Reviewed 1-5 transactions 6-10 transactions 11-25 transactions LOIs Submitted 10+ LOIs 0 LOIs >50 transactions 67% 26-50 transactions 6-10 LOIs 1-5 LOIs Junior debt providers reviewed a slightly lower number of transactions in Q4 15 82% of respondents reviewed more than 25 opportunities (versus 88% and 89% in the prior two quarters), and reviewed only 1-5 transactions. of respondents submitted no LOIs during the fourth quarter (10 submitted at least one LOI for the prior two quarters) Transactions Closed 17% 0 1 2 3 4 5 Closed transaction activity remains limited but steady 3
Fund Investments Market Average Multiples Debt/EBITDA Ratios <1.5 1.5-1.9 2.0-2.5 2.6-3.0 3.1-3.5 3.6-4.0 4.1-4.5 4.6-5.0 >5.0 Senior Debt - 11.1% 27.8% 33.3% 5. 22.2% - - - 61% of transactions in the last quarter were completed between 2.0x 3.0x senior leverage Total Debt - - - 11.1% 22.2% 22.2% 22.2% 22.2% - Junior Debt as a Percentage of Overall Capital Structure 67% of transactions in the last quarter were completed between 3.5x-5.0x total debt Junior Debt as a % of Total Capital Structure <5% 5%-1-1-2 21%-25% >25% Respondents - - 44.4% 33.3% 16.7% 5. The vast majority of junior debt investment continues to occupy - 2 of the total capital structure Equity (On a % Basis) That Must Be Below the Junior Debt % of Equity Below Junior Debt Realization < 2 20-29% 30-40-5 >5 Respondents 5. 11.1% 61.1% 22.2% - 94% of respondents indicated that there needs to be 2-5 of equity below junior debt, with 61% in the 3 - range (slightly less than prior quarters) IPO 3% Other 9% Internal Cash Flow 1 Sale of Company 3 Consistent with prior surveys, junior debt funds continue to realize exits through recapitalizations / refinancings and M&A Refinancing 42% 4
Transaction Specifics Returns Base Case Averages IRR <1 1 12% 13% 14% 1 17% 18% 19% 2 >2 Cash Pay - 16.7% 33.3% 33.3% - 5. - 5. - - - 5. - All-in IRR - - - 5. 16.7% 22.2% 27.8% 11.1% - 11.1% - - 5. 83% of respondents are at a 10-12% cash pay 78% of respondents aim for a base-case, all-in IRR of 13% - 1, up slightly from the majority at the 12% - range last quarter PIK PIK Rate Equity Rarely or Never Have PIK Rate 1% 2% 3% 4% 5% >5% 5. 11.1% 66.7% 16.7% - - - The pressure on cash pay and total returns is seen in the PIK component PIK has moved from 3% to 2%, up from the majority of respondents indicating <1% PIK in the previous two quarters % of Transactions with Warrants / Equity Participation We rarely or never make an equity co-investment 5% 1-25% Equity as a Percentage of Fully-Diluted Equity >5% 35% 1% 12% 2% 12% Approximately 67% of respondents reported over half of their transactions have warrants or other equity upside (including purchased equity), up substantially from 2 last quarter 51% - 99% 67% 2-5 5% 4% 3% 29% 41% of respondents reported warrants were 5% of fully diluted equity 5
Transaction Specifics (Continued) Equity (CONTINUED) Origin Equity coinvestment or purchased equity 88% Warrants issued as a result of providing junior debt 12% 88% of equity participation is in the form of purchased equity (as opposed to warrants) No-Call Provision 5 35% 2 5% Percentage of Transactions with No-Call Periods 5 17% 1% - 1-25% 2-5 51% - 99% 10 Respondents indicated 5 of transactions do not have call protection Another of respondents indicated all of their transactions have no-call periods -1 6 Average Length of No-Call Periods 5 4 2 Average length of no-call periods is 1-2 years 1 Year 2 Years 3 Years 6
Transaction Specifics (Continued) Prepayment Percentage of Transactions with Prepayment Penalties 8 64% 48% 32% 1 61% 1% - 1-25% 2-5 51% - 99% 10 Most transactions have some form of prepayment penalty Average Prepayment Penalty for First Year Debt 8 6 72% 4 The majority of prepayment penalties is typically 3% of the principal amount in year 1 2 17% 2% 3% 4% 5% >5% 7
Second Lien Market Overview All-in Rate Average All-In Rate on Second Lien 8% 9% 1 12% 13% 14% - 14.3% 14.3% 14.3% 21.4% 21.4% 14.3% All-in rate expectations in the second lien market were evenly distributed between 9% 14% this quarter, with most falling between 12% 13%. A 1 allin rate represented 5 of the market in Q3 15 Difference in Spread Between First and Second Lien 2.5% - 3% 8% 3% - 3.5% 8% Second liens at 13% increased to 35.7% in Q4 15 from 25. in Q3 15 and 8.3% in Q2 15 >=5% 4 4.5% - 5% 3.5% - 4% 4% - 4.5% 8% Respondents indicate the spread between the first and second lien is widening to 4.5%- 5.+ from 4.-4.5% Willingness to do a Second Lien Deal No A majority of respondents are willing to consider a second lien structure Yes 72% Second Lien Providers are Active Market Participants Yes No 61% Second lien providers are not seen as active market participants, a change from Q3 15 sentiment 8
Unitranche Overview Willingness to Provide a Unitranche Structure No We have seen a proliferation of capital providers willing to do an entire capital structure Yes 72% Unitranche structures are widely accepted as 72% of respondents will consider it Average All-In Rate on Unitranche >=12% 23% 8% 1 9% The majority of unitranche transactions are completed in the 8-1 range but have been widening 1 31% 9
Market Expectations Biggest Challenge Facing Junior Debt Providers Other Volatile Macroeconomic Environment 14% Uncertaininty Regarding Company Performance 12% Market Perspective on Ratios Aggressive Senior Debt Market 18% A unitranche structure that combines senior debt and junior debt into one layer of capital Competition from Junior Capital Providers 14% Aggressive senior debt markets and the proliferation of the unitranche structure are top concerns among junior debt providers. Respondents remain relatively evenly split regarding the biggest challenges facing the junior debt market 10 75% 5 25% 5 72% 61% 5 17% Senior Debt/EBITDA Total Debt/EBITDA EV/EBITDA Realizations Junior debt providers anticipate leverage levels to decrease across the board compared to the previous quarter 5 of respondents believe that enterprise valuations will decrease, compared to 48% of respondents anticipating they will stay the same in Q3 15 Covenants and Defaults 10 Increase Decrease Stay the Same 75% 5 72% 61% 5 Respondents anticipate an increase in covenant defaults and the need for companies to amend/extend 25% 44% Covenant defaults Monetary defaults Portfolio companies needing to 'amend and extend' Increase Decrease Stay the Same 10