private equity investing in 2016: panacea or 'hail mary

PROPRIETARY & CONFIDENTIALThe information contained in this presentation is proprietary and confidential and is provided to prospective investors solely for the purpose of evaluating an investment in the Lateral U.S. Credit Opportunities Fund, L.P. (the “Fund”) This information is not to be shared, distributed or otherwise used, for any other purpose or by any other individual, organization, company or business entity, without the prior written consent of Lateral Investment Management, LLC (“Lateral”).

LATERAL MARKET PERSPECTIVE, 19 April 2016Private Equity: a Panacea or ‘Hail Mary’ for Institutional Investors

2PRIVATE & CONFIDENTIAL

DISCLAIMER

The information contained in this presentation is proprietary and confidential and is provided to prospective investors solely for the purpose of evaluating an investment in the Lateral U.S. Credit Opportunities Fund, L.P. (the “Fund”). This information is not to be shared, distributed or otherwise used, for any other purpose or by any other individual, organization, company or business entity, without the prior written consent of Lateral Investment Management, LLC (“Lateral”).

This presentation is not an offer to sell securities of any investment fund or a solicitation of offers to buy any such securities. Securities of the Fund are offered to selected investors only by means of a complete offering memorandum, which contains significant additional information about the terms and risks of an investment in the Fund and shall supersede the information contained herein in its entirety. Securities of the Fund are not registered with any regulatory authority, are offered pursuant to exemptions from such registration and are subject to significant restrictions.

The information in this presentation was prepared by Lateral. The information is believed by Lateral to be reliable and has been obtained from public sources believed to be reliable. Lateral makes no representation or warranty, express or implied, as to the fairness, accuracy, completeness or correctness of such information, nor does Lateral or any of its affiliates accept any liability arising from its use. Opinions, estimates and projections in this presentation constitute the current judgment of Lateral and are subject to change without notice. Lateral has no obligation to update, modify or amend this presentation or to otherwise notify a recipient of this presentation in the event that any matter stated herein, or any opinion, projection, forecast or estimate set forth herein, changes or subsequently becomes inaccurate. No person has been authorized to give any information or make any representations not contained herein.

Investment in the Fund involves significant risks of loss of capital. There is no assurance that the Fund will achieve its investment objective and an investor could lose all or a substantial portion of his/her/its investment in the Fund. An investor should carefully review the Fund’s offering memorandum and consult with the appropriate financial, tax or legal adviser before investing in the Fund. The risks disclosed in this presentation do not include all of the risks and other significant considerations of an investment in the Fund.

The information provided herein shall not form the primary basis of any investment decision. Each investor should independently confirm such information and obtain any other information deemed relevant to an investment decision. A decision to invest in the Fund should be made after reviewing the Fund’s offering memorandum, conducting such investigations as the investor deems necessary and consulting the investor’s own advisers. Investors should not treat this presentation as advice in relation to legal, taxation or investment matters. Additional information may be available from Lateral upon request. This presentation is provided for informational purposes only


OVERVIEW: LATERAL INVESTMENT MANAGEMENT, LLC

Lateral is an innovative commercial finance company that provides growth funding and help for leading asset-based, owner-operated companies in the United States

Our focus is on short-term collateralized senior loans plus equity upside for growing, independent middle market firms

Company size criteria: $10MM-100MM in revenues, $2MM-10MM EBITDA Facing a discontinuous short-term growth event, need for $5MM-25MM in capital Existing hard assets, recurring revenue or long-term contracts No major private equity sponsor; owner-operated or family owned; opportunity to take 10-40%

equity stakes

We believe that private credit risk in the U.S. is priced at a significant premium over comparable public debt, a long-term opportunity because of dislocations in the banking system

Higher recovery rate in private debt because of more control, transparency and pricing Demand for capital significantly higher than supply accessible from banks and private equity

firms Large underserved market for debt addresses 350K businesses with $16MM average revenue


LEADERSHIP TEAM

Integrates credit and private equity expertise in the lower middle market to bring innovative funding solutions for growing companies

Background: General Partner, Highland Capital Partners, a Boston-based venture capital and

private equity firm with $3B in assets under management. Company operations and turnaround management as CEO, executive or co-

founder at 5 companies.

Education: MBA, Harvard Business School M.Phil., Cambridge University AB, Harvard College

Richard de Silva, Managing Partner

Background: CFO and Managing Director of Operations and Compliance at White Oak CFO/COO of Merriman Holdings, a publicly traded middle-market investment bank CFO of Pacific Growth Equities, COO of the bank’s asset management group Deloitte & Touche LLP

Education: BS, Accountancy, University of

Southern California CPA, State of California

Jack Thrift, Chief Financial Officer/Managing Director of Risk and Compliance

Background: Co-Founder, Managing Partner and Co-Portfolio Manager, White Oak Global

Advisors, a private debt fund with $1B in assets. Director, KKR Financial; handled more than $2B in new direct corporate loans Senior Portfolio Analyst for Franklin Templeton Funds’ multi-billion dollar distressed

debt portfolio

Ken Masters, Chief Investment Officer & Managing Partner

Education: MBA, Harvard Business School BS, Cornell University


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-0.5

0

0.5

1

1.5

2Japan 2Y OTR YIELDSweden 2Y OTR YIELDUSA 2Y OTR YIELDFrance 2Y OTR YIELDGermany 2Y OTR YIELDInflation CPI

NEGATIVE RATES AROUND THE WORLD, NEGATIVE REAL YIELDS FOR U.S. TREASURY BONDS

Yiel

d to

Mat

urity

(%)

Inflation

Source: Citi Velocity


0

100

200

300

400

500

600

700

800

900

1000OAS to Treasury, HYM

OAS to Treasury, USBIG

HY SPREADS WIDENED AND THEN TIGHTENED BACK, FALSE PERCEPTION OF REDUCED DEFAULT RISK

Source: Citi Velocity

Jan

Feb

Apr

Spr

ead

in Y

ield

ove

r Tre

asur

ies

(Bas

is p

oint

s)


PRIVATE MARKETS ARE AN INCREASINGLY IMPORTANT SOURCE OF YIELD AND RETURN FOR INVESTORS

Private

Public

Equity Debt

Non-sponsor-backed private credit plus

equity upside

Correlated sponsor-backed private debt financing

High PE entry valuations

Tighter access to debt financing

Volatile market compsLowered return outlook


GOOD PE RETURNS RECENTLY, BUT LONG TERM TREND IS DOWN

US PE premium to S&P

25 year: 3.5%

5 year: 1.4%


5X INCREASE IN PE INDUSTRY TO $4T IS UNPRECEDENTEDTo

tal A

sset

s U

nder

Man

agem

ent

Source: Prequin


ONLY $500B IN PRIVATE DEBT, MOSTLY PE-RELATED<$115B IN NON-PE RELATED DIRECT LENDING

Source: Prequin


EXCESSIVE SIZE OF PE INDUSTRY HAS LED TO HARMFUL OVER-“SPONSORIZATION” OF U.S. CORPORATIONS

Historically, Private Equity has played a positive role in improving the productivity of the U.S. economy, by fostering growth and increasing the scale of companies • Public/private arbitrage on multiples increasingly a function of excess leverage capacity, not

corporate efficiency, operating scale or rationalization

For the macro economy, shift in emphasis to financial engineering versus innovation and long-term growth• Excess financing costs versus investment in product and people• Agency cost of professional managers versus owner-operators• Build to scale and exit versus durable, long-term companies

For investors, illiquidity masks the volatility and cyclicality of the asset class• High variability in vintages based on market cycle• Long J curves and long term returns trending down• 40% of exits involve trading to other PE firms, in which institutions may already be an investor

For business owners, perverse incentives to sell early• Value creation going to sophisticated financial players, not business builders• Complexity: earn-out targets, separate debt and equity stakeholders• Undermines the foundations required to build long-term franchises and generational family-

owned businesses


THE CYCLE HAS TURNED IN PRIVATE EQUITY- 2014 LIKELY HIGH

2000 High

2007 High

2014 High ?


U.S. PE BACKED EXIT ACTIVITY HAS DROPPED BY 50%E

xit v

alue

($B

)N

umber of exits

Source: Pitchbook


U.S. PE-BACKED EXITS HAVE FALLEN OFF A CLIFF, ZERO 2016 IPOSE

xit v

alue

($B

)

Source: Prequin


ACTIVITY HAS SLOWED DOWN BUT, PLENTY OF DEALS CLOSINGD

eal v

alue

($B

)N

umber of deals closed

Source: Pitchbook


ENTRY MULTIPLES ARE STILL HIGHVa

luat

ion

mul

tiple

s

Source: Pitchbook


DEBT LEVELS ARE COMING DOWND

ebt p

erce

ntag

e of

tota

l val

ue

Source: Pitchbook


POTENTIAL FUTURE RETURNS IN PE UNLIKELY TO MATCH RECENT PERFORMANCE

Source: Bain 2016 Private Equity Report

Theo

retic

al m

ultip

le o

n in

vest

ed

capi

tal o

n le

vera

ged

buyo

ut d

eal


TIME TO SELL, NOT BUY PRIVATE EQUITY

700 funds in fundraising market – 2016 vintages are unlikely to perform as well as recent ones

LPs should ponder TPG founder David Bonderman’s comments earlier this year:

• “We’re selling everything that isn’t bolted to the ground” at an investor conference at the Beverly Hilton in February

• … but TPG announced reaching $10BB for a new fund later that month


LATERAL VS LENDER TO PE-BACKED COMPANIES

Origination In-house and proprietary Outsourced

Underwriting Direct fundamental analysis Proxy – depends on PE firm’s work

Pricing According to risk Auction – lowest cost debt provider wins

Structure and documentation

Covenant tight, collateral-focused and customized

Auction – covenant light, weakest terms wins

Portfolio management

Direct Through PE firm

Recovery Collateral-based and multi-faceted approach

Limited, typically an all-or-nothing scenario – must negotiate with PE firm

Lateral Non-Sponsored Financing

Typical Lender to PE-Backed Companies


Transitional growth capital: Funding a well-defined, discontinuous growth event for borrower to scale the size of operations

LATERAL’S APPROACH: SHORT-TERM COLLATERALIZED FINANCING AS CATALYST FOR EVENT-DRIVEN GROWTH AND THEN EXIT


PRE-INVESTMENT

Proven but sub-scale business model, strong

collateral but insufficient cash flow to accelerate growth or to

qualify for traditional bank financing.

POST-INVESTMENT

Company’s owners have scaled their business,

increased value of their holdings without significant

dilution.

18 to 36 months

EVENT-DRIVEN GROWTH: $5-25MM funding with discrete milestones. Lateral helps with strategic growth initiatives, capital expenditures optimization, customer intros, team building. Loan covenants are keyed to milestones

Rev

enue

Time

A

B

LATERAL’S EXITCompany has scaled successfully with demonstrated operating leverage and cash flow increasesLateral prepares company for refinancing or new equity fundingLateral facilitates process and provides transaction support

LATERAL’S ENTRYIdentify potential for inflection point in growth – 50-100% revenue increaseExisting and future plans to purchase additional capexWell defined milestones for company to move from A to B


HOW LATERAL PRICES RISK: IDIOSYNCRATIC, MARKET-NEUTRAL APPROACH

BASE CASE target unlevered gross return components

Gross unlevered annual return (%)

26.8%

Current pipeline target IRR

DOWNSIDE unlevered gross return components

Gross unlevered annual return (%)

24.8%


HOW LATERAL RE-PRICES RISK AND MAXIMIZES RECOVERY OUTCOMES IN A DEFAULT SCENARIO

Options for Recovery Pricing Risk

Waive breach and/or extend term Charge fee, increase rate

Mandate operating changes: reduced cost structure, capex limits Charge fee, increase rate

Sell specific assets Reduce exposure

Require junior capital Reduce exposure

Foreclose on capital stock and operate Run off and operate to sell

Force M&A Sell company

Foreclose and sell assets Sell assets at orderly liquidation value

Options for Recovery Pricing Risk

24

LOAN ILLUSTRATION (1 OF 3): LATERAL’S CREDIT VS. PRIVATE EQUITY FUNDING

Choice: Lateral or PE funding?

• Alpha is a fast growing manufacturer that wants to invest $10 MM in new plant to expand its capacity. Lack of scale drags down valuation.

• Owned by 2 strong-willed entrepreneurs, concerned about dilution and control issues.

Fit with Lateral criteria

• Compelling business inflection point: Potential to double revenues and increase margins from 10% to 20% with new plant.

• Incompatible with bank requirements: Cashflows will lag for 12 months years before the business shows long-run profitability.

• Strong collateral value: The equipment has a long life and multiple potential buyers.

• Exit plan: Plan to become >$10MM EBITDA positive in 2 years to set up PE and bank refinancing.

PE funding Bank loan Lateral loan• Low pre-money results in

60% dilution• Loss of control, board• Help to grow• Long-term equity partner

that requires an exit

• Fails coverage test due to low EBITDA

• Not a possible funding source

• 2.0-year tenor, focus on short-term growth

• 16% annual cost of capital

• Help to grow• No long-term control

Funding options

25

LOAN ILLUSTRATION (2 OF 3): LOAN TERMS AND CREDIT STATISTICS

Term sheet

Seniority: Senior to all other liens and payments

Additional collateral: Pledge of capital stockSize of loan: $10,000,000 Tenor: 2.0 yearsInterest: 14.0% + 2.0% PIKUnderwriting fees: 4.0%Pre-payment fees: NC Yr 1, 2.0% Yr 2Servicing fees: $25,000 per year

EquityWarrants for stock equivalent to most senior series

Put featureSell equity at 8x multiple of EBITDA 12 months after debt matures

Positive covenants Negative covenantsFinancial Performance:

Within 90% of projections, tested quarterly

Max Loan to Value:

Asset valuation plus cash equal to max 50% LTV

Quarterly Reporting:

Due 30 days after each quarter-end

Annual Audits:

Due 90 days after year-end

Asset Valuations:

Conducted annually

Cash Balance:

Equal to 12-month debt service excluding amortization

Change of Control Put:

Remaining principal and accrued interest plus 2%

Prepayment Fee:

102% of principal and accrued Interest

Key Person Put:

Any one of the two founders

Liens: Excluded Additional Debt:

None without LGI consent

Use of Proceeds:

Purchase of equipment and general corporate purposes


Scenario: PE now Scenario: LGI now, PE later0

50

100

150

200

250

Valu

e of

shar

es a

t exi

t ($

MM

)

More value upon exit for the founders

Founder equityvalue

Founder equityvalue

Significant value created or business owners by working with LateraI

Exit for Lateral• 2 years for debt, 3

years for equity• 20% IRR on debt • 2x return for equity• Overall 40% gross IRR

and 2.5x MOIC

LOAN ILLUSTRATION (3 OF 3): RETURNS AND BENEFITS FOR THE BORROWER

CONTACT US:

Margret (“Mags”) Hardardottiremail: [email protected]

Richard de Silva email: [email protected]

Ken Masters email: [email protected]

Lateral Investment Management, LLC 1825 South Grant Street, Suite 210, San Mateo, CA 94402www.lateralim.comPhone: 650-396-2200

mailto:[email protected]



http://www.lateralim.com/


PRIVATE EQUITY RETURNS BY VINTAGE YEAR


BET ON THE U.S. ECONOMY: FOCUS ON SMALLER COMPANIESCompany size of $10-100MM in revenues: 350K firms, 25% of jobs, $6 TT in revenues

Source: US Census 2012 County Business Patterns and 2012 Economic Census

351,148 firms

30 MM24.6% jobs

$5.8 TT in gross receipts

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Number of Firms Employment Estimated Revenues

>$100MM $10MM-100MM < $ 10 MMCategorized by firm size (annual revenues)

Perc

ent o

f tot

al in

the

US

econ

omy

6 MM firms 121 MM employees $ 30 TT in gross revenues

private equity investing in 2016: panacea or 'hail mary

Economy & Finance