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PS04045 Citi Newsletter WINTER 2008/2009

Contents Private Equity: Navigating the Changing Landscape

Leveraged 1 Mezzanine Debt Financing 7 Leveraged Buyouts values of private equity investments. Despite these changes, the key structural advantages of private Distressed Investing 8 These are challenging and extraordinary times in the equity and its continued focus on value creation have global financial markets. The severe market turmoil 9 not changed. of the last several months sent shockwaves through Important Information 11 the financial system and crippled the global We have often described the many structural markets. At the same time, recent data and forecasts advantages of private equity investing, which point to a continued weakening of the global economy include, among others, the ability to acquire active that is likely to continue throughout much of 2009 management or control of investments and the focus and potentially longer. on medium- to long-term value creation over an average five-year holding period. We believe these It is difficult to predict the ultimate impact of this structural advantages will help enable private equity challenging environment on the private equity managers to take the necessary measures to adapt to industry, given the uncertainty surrounding the this challenging environment. Given the recent magnitude and duration of the economic downturn, financial shocks and economic headwinds, private the pace of recovery, and subsequent economic equity managers are focused on their existing activity. One thing that is clear, however, is that the portfolio companies and what they can control— financial landscape today, supported by unprece- namely working closely with management teams to dented levels of government intervention, looks implement their value creation and operational vastly different from that of even a few months ago. improvement plans (e.g., through margin improve- Likewise, the private equity landscape has changed. ments, operational efficiencies, add-on acquisitions, For instance, private equity activity has declined and upgrading of management teams); adapting cost sharply amid the ongoing lack of financing and structures, working capital, and capital expenditures economic uncertainty; and new accounting rules are to the current environment; and ensuring that strong contributing to increased volatility in the reported capital structures with ample liquidity are maintained.

Figure 1: Announced Global LBO Volume by Deal Size The financial landscape today looks vastly different from that of < $500mm $500mm - $1bn $1bn - $5bn $5bn - $10bn > $10bn % of Total M&A even a few months ago. $700 30%

$600 25% $500 20% $400 15% $300 10% $200 LBO Volume ($ Billions) Percentage of Total M&A $100 5%

$0 0% 1999 2000 2001 2002 2003 2004 2005 2006 2007 YTD 2008

Source: Citi/Securities Data Company, September 30, 2008. YTD through September 30, 2008.

Investment Products: • Not FDIC Insured • No Guarantee • May Lose Value Citi Private Equity Newsletter WINTER 2008/2009

Another advantage that private equity has, relative to Slowdown in Private Equity Activity We believe the structural some other asset classes, is that private equity invest- Since the initial dislocation in the credit markets that advantages of private ments generally have long-term financing in terms of began in mid-2007, private equity deal activity— equity will help managers both debt and equity. Not only do private equity both in terms of new investments and realizations— navigate the challenging managers typically plan to hold portfolio invest- has slowed significantly. In the first three quarters of environment. ments for an average of five years, but they retain the 2008, we saw some pockets of new investment activity. ability to contribute additional equity to support This activity, however, was largely confined to deals portfolio companies through a cyclical downturn in the small- and middle-markets, which rely less should it be required. Furthermore, many of the heavily on large debt packages, and in defensive or investments that were completed in the 2006 to 2007 less cyclical sectors such as energy and healthcare. period were financed with flexible capital structures, Looking for alternative ways to deploy capital amid which include long-tenored debt (i.e., six-to-eight the , some firms began moving into less year maturities), limited mandatory amortization traditional private equity investments such as distressed payments, loose or no maintenance covenants, leveraged loans and minority investments, including and/or payment-in-kind toggle notes, providing private growth-equity deals and private placements in public equity managers with the time and optionality to companies. Other firms invested more funds abroad, navigate the difficult times. particularly in emerging markets, including businesses As the credit crisis and recent market turmoil impact in China, India, Central and Eastern Europe, and the overall economic environment and weakness in the Middle East. consumer and business spending becomes more Private equity firms were also forced to use creative widespread, portfolio companies are facing more structures and look beyond traditional sources of difficult operating conditions. Indeed, we are seeing debt and equity financing to complete new deals. the current economic weakness impacting the For instance, one of the largest deals in 2008 was the performance of companies in existing private equity acquisition of by NBC Universal, portfolios. That said, even with the economy in the , and , announced midst of a recession, there are portfolio companies, in July, for approximately $3.5 billion. Two hedge including some that are consumer-facing, that are funds, GSO Capital Partners and Sankaty Advisors, performing quite well. provided subordinated debt for this transaction.

Figure 2: Purchase Price vs. Debt Multiples for Leveraged Buyouts

Purchase Price Multiple (Issuers with EBITDA of More than $50mm) Purchase Price Multiple (Issuers with EBITDA of $50mm or Less) Debt Multiple (Issuers with EBITDA of More than $50mm) Debt Multiple (Issuers with EBITDA of $50mm or Less)

11x 11x 10x 10x 9x 9x 8x 8x 7x 7x 6x 6x

5x 5x Debt Multiples

Purchase Price Multiples 4x 4x 3x 3x 2x 2x 2000 2001 2002 2003 2004 2005 2006 2007 YTD 2008

Source: Standard & Poor's Third Quarter 2008 Leveraged Review. YTD through September 30, 2008. Includes U.S. LBOs only. Purchase price multiples exclude media, telecom, energy, and utility deals prior to 2003. Debt multiples exclude media and telecom deals.

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Figure 3: Average Equity Contribution to Leveraged Buyouts Private equity deal activity—both in terms Equity Contribution of new investments and realizations—has 45% slowed significantly. 40%

35%

30%

25%

20%

15%

Equity as a Percentage of10% Total Sources YTD ‘08‘07‘06‘05‘04‘03‘02‘01‘00‘99‘98‘97‘96‘95‘94‘93‘92‘90‘89

Source: Standard & Poor's Third Quarter 2008 Review. YTD through September 30, 2008. There were too few deals in 1991 to form a meaningful sample. Excludes rollover equity. Includes U.S. LBOs only.

The deal also provides an illustration of how private U.S. issuers with more than $50 million of EBITDA equity firms are partnering with corporate buyers to were financed based on an average total debt to make new investments.1 EBITDA multiple of 4.9x during the first nine months of 2008, down from a record 6.2x in 2007. Overall, global leveraged buyout volume announced Over the same period, the debt multiple for U.S. in the first nine months of 2008 totaled $97.6 issuers with $50 million or less of EBITDA fell to billion, representing an 81% decline from the same 4.5x from 5.6x in the previous year (see Figure 2).4 period in 2007. During this period, there was not a In those cases where had been available to single leveraged buyout announced that exceeded finance private equity transactions, it was much more $5 billion, compared to twenty deals announced that expensive and carried significantly more conservative exceeded this amount in 2007. With less private terms than that which was available over the past equity activity, the asset class is playing a much several years. Spreads have widened and borrowing smaller role in the overall M&A market. In the first rates have increased, and sponsor-friendly structures three quarters of 2008, private equity firms bought such as covenant-lite and payment-in-kind toggle or sold $376.4 billion worth of companies, account- notes have disappeared from the market. ing for 15.1% of total M&A, the lowest percentage in five years. While still high by historical standards, We have also witnessed a disconnect between the this percentage compares to 23.7% in all of 2007 pricing expectations of buyers and sellers, contributing and a record 24.6% in 2006 (see Figure 1).2 further to a slowdown in private equity activity. With significantly less leverage available, purchase price Even before the unprecedented market turmoil that multiples have begun to adjust downward, leading to began in September 2008, extremely tight credit lower entry valuations that private equity firms pay conditions since mid-2007 have made financing new for portfolio companies. The average purchase price investments increasingly difficult. During the first multiple for U.S. buyouts of companies with more nine months of 2008, sponsor-related loan volume than $50 million of EBITDA dropped slightly to fell 77% compared to the same period in 2007.3 9.7x in the first nine months of 2008, compared With significantly less leverage available, average to a record 9.8x in all of 2007.5 Purchase price debt multiples also fell. LBO transactions involving multiples for the small- and middle-markets have

1 Merissa Marr and Peter Lattman, The Wall Street Journal, “NBC-Led Group Will Buy the Weather Channel,” July 7, 2008. 2 Citi/Securities Data Company, September 30, 2008. 3 Standard & Poor’s Third Quarter 2008 LCD Quarterly Review. 4 Standard & Poor’s Third Quarter 2008 Leveraged Buyout Review. Excludes media and telecom deals. 5 Standard & Poor’s Third Quarter 2008 Leveraged Buyout Review. Excludes media, telecom, energy, and utility deals prior to 2003.

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Periods of market Figure 4: Returns in the U.S. and Europe uncertainty are almost U.S. Buyouts European Buyouts always accompanied Median Quartile Upper Quartile Median Quartile Upper Quartile by a slowdown in private equity activity. 60% 60%

50% 50%

40% 40%

30% 30% Net IRR Net IRR 20% 20%

10% 10%

0% 0% ‘04‘02‘00‘98‘96‘94‘92‘90‘88‘86‘84 ‘04‘02‘00‘98‘96‘94‘92‘90‘88‘86 Vintage Year Vintage Year

Source: Venture Economics/Thomson as of June 30, 2008.

adjusted more quickly, with the average purchase Despite some deal activity in the first nine months of price multiple for buyouts of companies with the year, it has become even more difficult to finance EBITDA of $50 million or less falling to 8.4x in the transactions following the unprecedented events of first nine months of the year, compared to 9.3x in September 2008. As a result, new private equity all of 2007 (see Figure 2). Purchase price multiples, activity for all but the smallest deals and certain however, have not fallen as quickly as debt multiples add-on acquisitions has largely been put on hold. and remain high by historical standards. Many buy- We expect that private equity activity will remain ers are waiting on the sidelines with the expectation slow until credit becomes more widely available and that valuations will continue to fall more in line with there is some clarity on the economic environment debt multiples and with public company trading going forward. multiples, which have declined along with global It is important to remember, however, that periods of stock indices. At the same time, declining purchase market uncertainty are almost always accompanied price multiples are presenting a challenge to sellers, by a slowdown in private equity activity. Success is whose pricing expectations remain high and must not determined by the amount of new investment recalibrate to the current market reality. activity or even realization activity, but by how well With purchase price multiples falling at a much a private equity fund’s portfolio companies perform slower rate than debt multiples, deals require greater operationally over the life of an investment and by amounts of equity. The average equity contribution what valuation is realized upon exit. In today’s to U.S. LBOs in the first three quarters of 2008 environment, private equity managers are even more jumped to 38.9%, an all-time high, from 30.9% focused on facilitating sustainable growth at existing for all of 2007 (see Figure 3).6 For example, it is portfolio companies by working with management reported that for the acquisition of the Weather teams to implement their value creation and Channel, equity accounted for slightly more than operational improvement plans and completing half of the approximately $3.5 billion purchase price.7 selective add-on acquisitions. The $4.1 billion buyout of ConvaTec, Bristol-Myers While the near term remains murky, history suggests Squibb’s wound therapeutics and ostomy-care unit, that these cycles present significant profit potential by and Avista Capital Partners in for long-range investors. Indeed, historical private May 2008 also reportedly was structured with equity equity returns have been attractive through multiple accounting for approximately 50% of the deal’s value.8 economic and capital market cycles and have been

6 Standard & Poor’s Third Quarter 2008 Leveraged Buyout Review. 7 Christine Idzelis, Jonathan Braude, Nathaniel Baker, and Luisa Beltran, The Deal, “Deep in the Funk,” September 26, 2008. 8 David Carey, The Deal, “Equity slice helped ConvaTec deal,” May 5, 2008.

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particularly strong coming out of times of economic already come under some pressure. The Dow Jones The adoption of FAS weakness—for instance, in the early- to mid-1990s Industrial Average, the S&P 500, and the Nasdaq 157 is contributing to and the 2001 to 2002 period (see Figure 4). Composite Index fell 33.4%, 39%, and 42.1% during increased volatility Citi Private Equity (“CPE”) believes that once the the first eleven months of 2008, respectively.9 As a in the reported values economic environment becomes less opaque and result, certain portfolio company valuations, which of private equity credit eases, private equity firms will move to take are based in large part on the valuation metrics of investments. advantages of the opportunities that develop from comparable public companies and private market the current turmoil. transactions when relevant, have been negatively impacted. That said, even with the fall in the public New Accounting Rules equity markets and deteriorating economic conditions, Another factor that is having a considerable impact a number of other portfolio companies have been on the private equity landscape is the adoption of written up under the new accounting rule. Financial Accounting Standards Board Statement 157, Another implication of FAS 157 is that it may relieve Fair Value Measurements (“FAS 157”) by private equity some of the pressure facing pension funds and other funds. The new accounting rule establishes a framework limited partners that are finding themselves for measuring the fair value of illiquid investments, approaching or even exceeding their target allocations such as private equity investments, under generally for private equity in their portfolios as public market accepted accounting principles (GAAP), in order to values have declined—the so-called “denominator increase consistency and comparability in fair value effect.” For example, following the bursting of the measurement and the related disclosures. FAS 157 dot-com bubble in 2001, a number of limited partners was issued in September 2006 and mandated that found themselves overallocated to private equity firms implement these policies effective for the fiscal as the value of their investments in other asset classes year beginning after November 15, 2007. declined, yet the corresponding valuations for their Private equity investments are long-term, illiquid private equity investments had not yet fallen. assets, and hence determining the value of an invest- This disconnect between public market and private ment at a given point in time can be difficult and equity valuations forced some limited partners to sell highly subjective. Historically, many private equity their private equity stakes in the secondary market or managers, particularly U.S.-based firms, had held to restrict making new commitments to the asset their portfolio companies at cost until a significant class. Once again, the recent market turmoil has led event, such as a recapitalization or an exit, or a material to declines in the value of non-private equity assets decline in a company's performance occurred. in limited partners’ portfolios. These declines, coupled with fewer distributions (which reduce the net However, under the new accounting rule, private exposure to the asset class) from private equity funds equity firms are required to provide an estimate of amid the weak realization environment, mean the fair value of each of their portfolio investments as that many limited partners are once again suffering of the reporting date and develop the processes to from the denominator effect. Already some limited support their reported values. In order to determine partners are looking to sell certain of their private the fair value of their portfolio investments, private equity investments in the secondary market and equity managers will review a number of factors, reducing new investments to private equity funds. including a portfolio company’s most recently available With public market and private equity valuations operating and financial results; relevant valuation more closely aligned under FAS 157, however, other metrics and financial performance of comparable limited partners may be able to avoid this scenario as public or private companies; prior transaction valuation reported private equity valuations adjust to reflect multiples of similar companies; and other company- overall declines in the public markets. and market-specific characteristics. Although these private equity valuations provide an The adoption of FAS 157 will likely result in estimate of an investment’s value as of the valuation increased volatility in the carrying values of portfolio date, we believe these interim valuations are not companies from quarter to quarter. Clearly with a necessarily determinative of what a limited partner softer economy and weaker stock market performance, will ultimately realize on an investment in a fund. the valuations of certain portfolio companies have

9 Bloomberg, November 30, 2008.

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What ultimately matters is how well portfolio of the global economy are impacting the perform- Private equity managers companies perform operationally over the long-term ance of certain companies in existing private equity are facing a more difficult and what valuation is realized upon exit of an portfolios. At the same time, we are seeing additional realization environment. investment. Importantly, since private equity pressure on the valuations of portfolio companies as managers can control the timing of their exits, we a result of FAS 157. believe it is unlikely that private equity managers will Given private equity’s long-term nature, investments choose to exit their portfolio investments in are generally exposed to a variety of economic cycles the current environment, unless an attractive and credit environments. We believe this long-term opportunity materializes. focus, coupled with the key structural advantages of Conclusion private equity and the flexible capital structures of many of the companies that were acquired in the The private equity landscape today looks very different 2006 to 2007 period, should provide managers with from that of the last several years. Still, CPE believes the time needed to make operational improvements, the key structural advantages of private equity and its increase profits, and otherwise enhance the value of core focus on value creation have not changed. their portfolio companies and position them for future Recent market turmoil and the continued weakening exits, despite what we expect will be a tough environment.

Focus on the Realization Environment

The same factors that have negatively impacted new deal activity—namely the ongoing credit crunch, market uncertainty, and deteriorating economic conditions—are leading to a more difficult realization environment for private equity investments as well. Indeed, with less credit available, dividend recapitalizations and sales to other financial sponsors, known as secondary buyouts, have become increasingly difficult to complete. Given the weak stock market performance over the past year, it has also become more difficult and less attractive to use IPOs as a means to exit portfolio companies. Whereas over the last several years, IPOs accounted for more than 40% of the total in the U.S., in the first half of 2008, only six IPOs, or 23% of the total, were backed by financial sponsors.10 The U.S. IPO market remained frozen until mid-November 2008 when Grand Canyon Education (Nasdaq: LOPE), a Phoenix-based online education provider backed by an investor group including private equity firm Endeavour Capital, raised $126 million in an IPO—the first IPO in the U.S. since August 2008.11 What little realization activity has occurred generally involved the sale of a portfolio company to a cash-rich strategic buyer, and in many cases, to non-U.S. strategic buyers. For instance, in August 2008, Cerberus Capital Management announced its sale of Talecris Biotherapeutics, the blood-plasma unit that was carved out of German conglomerate Bayer in early 2005, to Australian plasma-product maker CSL for $3.1 billion.12 Despite the challenging environment, there were still several other notable exits in 2008. For instance, in August, defense contractor General Dynamics announced its acquisition of Swiss-based Jet Aviation Management for approximately $2.25 billion. Jet Aviation provides maintenance, overhaul, and refurbishment services for corporate jets, and was owned by the private equity firm . Permira, which acquired Jet Aviation in October 2005, grew the business, in part, by purchasing U.S.-based Midcoast Aviation in March 2006 and Savannah Air Center in January 2008.13 Another notable exit is the acquisition of Alltel by Verizon Wireless, a joint venture between Verizon Communications and Vodafone Group, for $28.1 billion and announced in June—just seven months after TPG and Capital Partners acquired the company.14 Nevertheless, since the deepening of the credit crunch in September 2008, profitably exiting investments has become even more difficult, and we expect the realization environment will remain tough for some time. Private equity managers, however, are able to be opportunistic, particularly as it relates to exits. It is the option value of private equity that provides managers with the flexibility to time an exit in order to increase the value of an investment. Given private equity’s long investment horizon, it is unlikely that private equity managers will choose to exit their portfolio investments in the current environment. Instead, if feasible, we believe private equity managers will try to wait out the cycle and look to exit their investments once market and economic conditions change and valuations improve.

10Lynn Cowan, The Wall Street Journal, “Financial Sponsor IPOs on the Wane,” July 14, 2008. 11Carolyn Murphy, The Deal, “Grand Canyon prices IPO,” November 20, 2008. 12Peter Lattman and James Mawson, The Wall Street Journal, “Carlyle & Cerberus Remember Why They Got Into Private Equity,” August 13, 2008. 13August Cole and J. Lynn Lunsford, The Wall Street Journal, “General Dynamics to Buy Jet Aviation for $2.25 Billion,” August 20, 2008. 14Serena Ng and Peter Lattman, The Wall Street Journal, “Alltel Deal Yields a Big Profit,” June 6, 2008.

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Mezzanine Debt Financing category of jumbo mezzanine issuance, amounting Mezzanine debt can be to €2.5 billion and accounting for 58% of total Since the dislocation in the credit markets began an attractive source of mezzanine issuances—well above relative levels in the summer of 2007, mezzanine debt firms have financing during difficult recorded in recent years (see Figure 5).16 economic times. successfully raised funds and proactively supported new transactions at considerably better pricing While no reliable third-party data exists on U.S. and with more conservative structures than those mezzanine debt issuance, U.S. small- and middle- transactions completed before the pullback in the market LBO activity is a useful proxy. We have global credit markets. Mezzanine debt has returned previously discussed how the volume of small- and as a key part of the while other middle-market transactions had held up relatively forms of junior debt have all but disappeared, well following the dislocation in the credit markets and consequently, mezzanine debt has played a last summer, particularly when compared to the significant role in the structuring of various large-market. It remains true that small- and middle- leveraged buyout transactions completed in 2008. market buyouts represent a larger percentage of total LBO volume than they did in 2006 and the first half The stable nature of mezzanine debt has typically of 2007. The renewed turmoil in the credit markets made it an attractive source of financing during that began in September 2008, however, has difficult economic times. Year-to-date as of now taken its toll on small- and middle-market September 30, 2008, mezzanine funds raised transactions as well, as senior (first-lien) debt has $36.9 billion across 13 funds, compared to become difficult to obtain. $3 billion across nine funds raised during the same period in 2007.15 In the European market, with large Interestingly, in the U.S., as large-market private amounts of capital to invest, mezzanine funds are equity firms refocused their efforts on smaller well-equipped to handle the demand for new transactions, they have increasingly relied on large mezzanine issuances, which, according to Fitch mezzanine loans to help finance their deals. Ratings, has been increasingly geared towards In August 2008, The Blackstone Group used a “jumbo” transactions, or facility sizes in excess of $175 million mezzanine loan provided by Credit €200 million. Of the 26 European mezzanine deals Suisse and GE Capital to complete its $750 million that Fitch tracked in the last 12 months ending acquisition of Allied Barton Security Services, while September 30, 2008, seven transactions fell into the and Riverstone Holdings tapped

Figure 5: European Mezzanine Issuance by Facility Size

< 50mm 50mm – 100mm 100mm – 200mm > 200mm € € € € € € 14,000 € 12,000 € 10,000 € 8,000 €

Millions 6,000

€ € 4,000 € 2,000 € 0 2000 2001 2002 2003 2004 2005 2006 2007 LTM Q308

Source: Fitch Ratings, September 30, 2008.

15Keenan Skelly, Dow Jones Private Equity Analyst, “Fund-Raising Holds up Surprisingly Well,” October 2008. 16Fitch Ratings, “Performance Anxiety—European Mezzanine Debt: The Legacy of 2006 and 2007,” October 10, 2008.

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Amegy Bank and CIT Group for a $125 million structures of many of the deals financed in the The current environment mezzanine tranche to support their acquisition of 2006 to 2007 period appear to have mitigated some is likely to translate Hudson Products.17 As discussed earlier, GSO and of the increase in defaults in 2008. Loose covenants into new investment Sankaty Advisors also provided a large mezzanine loan have made it easier for issuers to avoid technical opportunities for to help finance the acquisition of the Weather Channel. defaults (i.e., triggering a covenant) if company distressed managers. performance deteriorates dramatically. Likewise, The relative amount of mezzanine debt placed in long-tenored debt, payment-in-kind toggle notes, the average middle-market deal has also increased. and limited mandatory amortization payments have In the third quarter of 2008, the average U.S. provided issuers with extra time to navigate the middle-market deal, defined as acquisitions of target difficult environment. companies with less than $50 million in EBITDA, carried a mezzanine multiple of about 1x EBITDA. While still low by historical standards—the average This figure has grown on a quarterly basis since the default rate between 1971 and 2007 was 3.1%—and second quarter of 2007, when middle-market LBOs nearly a quarter of the peaks reached in 2002 and carried roughly 0.2x EBITDA of mezzanine.18 1991, high yield bond defaults are expected to continue to rise well into 2009 and perhaps longer. It is evident that mezzanine has returned to favor, How high default rates will go largely depends on attracting a new type of issuer and accounting for a the duration and depth of the economic downturn, larger share of issuers’ capital structures. but industry participants and observers alike generally expect the high yield bond default rate to Distressed Investing climb to the high single digits or low double digits in the second half of 2009. With the credit markets essentially frozen and One indication that the default rate is expected to economic conditions continuing to deteriorate, it is rise is the dramatic increase in the distressed ratio clear that the cycle of benign credit, which began in recorded in recent months. The distressed ratio, or 2003 and continued largely unabated through the the value of distressed debt (defined as bonds trading first half of 2007, has turned. Abundant liquidity, at least 1,000 basis points over 10-year Treasuries) as particularly in 2006 and early 2007, made it easier a proportion of the high yield bond market, reached for distressed companies to refinance their debt a record 40.2% at the end of the third quarter of obligations and helped support near-record low 2008, nearly double the ratio of 21.5% at the end of default rates. However, with a weakening economy, the second quarter and almost four times the ratio as a slowdown in corporate earning growth, and the of year-end 2007 of 10.4%. Indeed, a higher credit markets severely dislocated, an increasing distressed ratio in large part reflects the widening number of companies are finding it difficult to service spread between the yield-to-maturity on high yield and/or refinance their debt obligations, and default bonds (measured by the Citi High Yield Bond rates are beginning to rise. Market Index) and 10-year Treasuries, which The U.S. high yield bond default rate increased to an increased to 1,038 basis points at the end of the third annual rate of 2.22% in the third quarter of 2008, quarter of 2008 and as high as 1,567 basis points in from 1.83% in the second quarter (these numbers mid-October, the widest on record. Due largely to exclude the bankruptcy since the rise in the distressed ratio, the face value of the Lehman Brothers’ bonds were rated investment-grade defaulted and distressed debt market is estimated to prior to its bankruptcy and default). Likewise, the have increased to roughly $1.82 trillion as of annual default rate for U.S. leveraged loans increased September 30, 2008, up from $1.14 trillion as of to 1.91% from 1.7% as of the second quarter.19 June 30, 2008. This figure rises to nearly $2 trillion While default rates are on the rise, the flexible capital when adding in Lehman Brothers’ defaults.

17Ari Nathanson, Buyouts, “Mezzanine Grows More Attractive Yet in Market Turmoil,” October 6, 2008. 18Standard & Poor’s Third Quarter 2008 High-End Middle Market Lending Review. 19The source for this and all other data in the Distressed Investing overview, unless otherwise noted, is: Citi, “Altman High Yield Bond Default and Return Report: Third Quarter 2008 Review,” November 5, 2008.

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The factors contributing to a rise in defaults have Venture Capital As the financial crisis also helped fuel an increase in the number of Unlike the dot-com bust of 2000 to 2002, the has unfolded, it has bankruptcy filings in 2008. There were 92 filings venture capital industry is not at the center of the become clear that the with liabilities greater than $100 million during the current financial crisis. The bubble of the late 1990s venture industry is not first nine months of 2008 (compared to just 38 was fueled by investors who poured billions of dollars immune to the difficult filing for all of 2007), of which twelve filings were of capital into internet, technology, and telecom environment. for companies with more than $1 billion of companies with questionable business models at liabilities. The most notable was Lehman Brothers’ unsustainable valuations. This time around, the filing on September 15, 2008, with $613 billion of crisis has largely stemmed from an unsustainable liabilities, making it the largest bankruptcy ever and housing boom that fueled an insatiable desire for nearly six times greater in size than WorldCom’s debt, which has led to a de-leveraging of household, filing, which had previously held the record. enterprise, and investor balance sheets and a Clearly, the current environment is likely to translate widespread economic slowdown. into new investment opportunities for distressed Conventional wisdom is that compared with other managers. However, many distressed private equity alternative assets, such as leveraged buyouts, real funds are moving slowly to deploy capital, even estate, and hedge funds, venture capital investments though default rates are rising and distressed seem relatively “safe,” as venture firms and their managers have quite a bit of dry powder after record companies are not as reliant on the debt markets for levels of fundraising in 2007. It is still early in the financing. Venture firms make equity investments cycle and purchase price multiples remain high by and do not use leverage or financial engineering to historical standards. Many distressed managers are help drive returns. However, as the financial crisis therefore sitting on the sidelines when it comes to has unfolded, it has become clear that the venture new investment opportunities and waiting for industry is not immune to the difficult environment. valuations to fall further. Based on the expectation that the economy will continue to weaken and For example, the crisis is causing many venture- defaults will climb, distressed managers believe a new backed companies to postpone or shelve their IPO wave of highly attractive distressed opportunities will plans. Fewer venture-backed companies have gone present themselves in the short- to medium-term. public in 2008 than in any year since 1977, with only one IPO reported in the third quarter of 2008 and six for the first nine months of the year (see Figure 6).20

Figure 6: Venture-Backed IPO Activity

Amount Raised Number of IPOs

$25 250

$20 200

$15 150

$10 100 Number of IPOs

Amount Raised ($ Billions) $5 50

$0 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 YTD 2008

Source: Venture Capital Industry Overview by Dow Jones Venture Source, September 30, 2008. YTD through September 30, 2008.

20Venture Capital Industry Overview by Dow Jones Venture Source, September 30, 2008.

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In the M&A market, buyers’ inability to obtain credit, will fold or simply not invest during this period, We believe this the instinct to hold onto cash, and declining equity leaving markets open for new entrants to capture downturn will not have markets, which make stock a less desirable form of substantial market share. as big of an impact on currency, have all contributed to a slowdown in In terms of the current investment environment, it is the venture industry acquisition activity. as that which followed very similar to that of 2002 to 2003, a period during the dot-com bust In addition to the lack of acquisitions and IPO exits, which numerous venture firms took advantage of from 2000 to 2002. deteriorating economic conditions are likely to lead difficult market conditions and attractive valuations to markdowns of venture portfolio values in the and found compelling investment opportunities on coming quarters. Numerous companies in venture which they achieved very good returns. Firms and portfolios have already experienced material changes their portfolio companies are beginning to see a in their ability to close new business and have been number of value-based investment or acquisition impacted by slower sales cycles, reduced consumer opportunities in good companies with distressed and business spending, and downward pricing shareholders who need to sell at almost any price to pressure. Many of these companies will require get liquidity. This creates a positive environment for outside funds in the near future and will face a difficult investing in solid companies at attractive valuations. fundraising environment characterized by lengthy Furthermore, we believe technological innovation financing timelines and suppressed valuations. will continue apace. Most venture-backed companies In anticipation of a prolonged recession, venture are technology-driven startups with deep intellectual firms are employing the lessons they learned from property, and technological innovation is minimally 2000 to 2002. They are ensuring that they have correlated to the macroeconomic fundamentals of plenty of capital reserved for existing investments the U.S. and global economies. that they believe can succeed despite the challenging Accordingly, we continue to believe that top-tier economic conditions, and advising their companies to venture firms will be well-positioned to achieve sharpen operating plans, preserve cash where possible, attractive returns for their investors over the life of and lengthen financial runways to the next value their funds. These firms are patient, long-term inflection point. We believe that this strategy of business builders that back world-class entrepreneurs proactive portfolio management will help the best who apply innovation to solve key business venture-backed companies weather the current storm problems. Entrepreneurs and venture firms continue and emerge on the other side as stronger businesses. to build businesses, realizing that great companies When the economy rebounds, such companies are are conceived of and built in both up and down poised to grow quickly and establish themselves as markets and that strong management, execution, market leaders. and financial support can overcome tough conditions. Despite the gloom, we believe this downturn will not have as big of an impact on the venture industry as that which followed the dot-com bust from 2000 to 2002, when technology companies were less efficient and burned more cash. Most venture firms are run by seasoned executives who remember that period and are familiar with the prudent actions required to navigate such challenging times. Indeed, we believe that for those venture firms and portfolio companies with the right resources and support, this represents a time of great opportunity. Historically, many great companies have been started during difficult economic times when other investors and entrepreneurs were skittish, and in some cases, their success was due to their ability to thrive while their competitors were struggling to stay afloat. We believe that the current economic environment presents similar opportunities. Many competitors

10 Citi Private Equity Citi Private Equity Newsletter WINTER 2008/2009

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