Specialty Finance


September 18, 2009

Things Starting To Look Up, State of the Middle Market Dinner Recap
Greg Mason, CFA Troy Ward Jonathan Bock, CFA (314) 342-2194 (314) 342-2714 (314) 342-2918 masong@stifel.com wardt@stifel.com bockj@stifel.com

We recently hosted our second "State of the Middle Market Dinner" which featured three middle market participants; David Golub (Golub Capital - private debt), Chuck Brizius (Thomas H. Lee Partners - private equity) and Michael Arougheti (Ares Capital – public provider of private debt). The dinner was held in Boston and was a successful follow-up to our New York event held in early June. One of the not so subtle differences at this event was the overall "tone" regarding the current environment. Below are the key takeaways from the dinner: • Economic Performance: EBITDA levels have stabilized but limited revenue drivers will prevent a quick EBITDA rebound. • Middle market pricing remains attractive. A significant credit market rebound in liquid investments (large syndicated loans & high yield bonds) has not caused irrational pricing in the illiquid middle market. • The favorable lending environment is likely to continue as banks and irrational competitors will not likely to return to the markets for a significant period of time. • The pipeline for new (primary) investment opportunities is building rapidly and 4Q09 should see significantly higher M&A volumes. • A massive $800 billion in debt ($300 billion in debt refi and $500 billion to fund new private equity deals) is needed in the next two years. This is expected to be met by new capital and "amend & extend". This should extend the attractive lending environment. • Final Tidbit: The panel was unanimous in the view that the public equity markets have likely overshot the fundamental economic trends and the credit markets are lagging the equity euphoria. Economic Performance: EBITDA Levels Have Stabilized but Limited Revenue Drivers Will Prevent a Quick EBITDA Rebound. One of the advantages of having three middle market participants is their insight into the current state of operations at their portfolio companies. Overall the assessment was that EBITDA has stabilized for the most part and several sectors are showing slight improvement in EBITDA. One area that was pointed out as still under pressure was luxury goods which were described as "still struggling". Outside of industry exposure the best protection against EBITDA compression was aggressive management at the portfolio company level. Managers who recognized the severity and implemented cut costs early have protected substantial value. While EBITDA levels are stable, all three speakers see limited revenue growth which is the needed catalyst to begin driving EBITDA levels higher. As a result, they expect a "muddling our way along" with flat to slowly rising EBITDA levels for the foreseeable future. Middle Market Pricing Remains Attractive. Significant Credit Market Rebound in Liquid Investments (Large Syndicated Loans & High Yield Bonds) Has Not Caused Irrational Pricing in the Illiquid Middle Market. Similar to our NYC event, the participants provided prevailing middle market pricing levels for senior debt, mezzanine debt (aka subordinated debt) and "uni-tranche" opportunities. First, leverage levels have declined meaningfully due to a combination of lower overall purchase multiples and larger equity contributions. See Figure 1. Last out debt is now only 3.5x EBITDA versus 5.5X at the peak of the market. In addition, the lower multiples today are based on recession-level EBITDA whereas the higher multiples at the peak of the market were also based on peak EBITDA levels. As a result, on an actual dollar basis leverage and purchase values have fallen dramatically. Second, total returns are very attractive in the middle market with IRR's of 9-11% for senior debt and 18-20% for mezzanine debt. See Figure 2. Given the scarcity of capital in the market, the participants that do have capital are finding the uni-tranche product (combination of senior and sub debt) very attractive. This product allows the provider to be the only debt in the transaction and offering an attractive blended rate while retaining the senior position.

All relevant disclosures and certifications appear on pages 4 - 5 of this report.

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Specialty Finance Figure 1 - Purchase & Leverage Multiples (2006/2007 vs Current)
Purchase & Leverage Multiples (2006/2007 vs Current) Multiples of EBITDA Total Purchase Price 2006/2007 Vintage Current 8-10x 6-7x Senior Debt 4x 2-2.5x Mezzanine Debt 4-5.5x 3.5x Equity as a % of Total Purchase 33% 50%

September 18, 2009

Equity 2.5-4.5x 3.5x

Note: 2006/2007 multiples were on peak EBITDA levels while current multiples are on recession EBITDA levels. Thus on a dollar basis leverage and purchase prices have fallen significantly. Source: State of the Middle Market discussion

Figure 2 - Current Market Pricing For New Middle Market Loans (Primary Issuance)
Current Market Pricing For New Middle Market Loans (Primary Issuance) Total Cash PIK Interest Interest Interest Rate L+ 6-8% Senior Debt w/ LIBOR None 8-10% floor of 2% Mezzanine Debt 11-13% 2-3% 13-16%

Upfront Fees 2%

Prepayment Penalties Not mentioned as a key return component Pre-payment penalties of 35% stepping down to zero over life of the loan

Total IRR 9-11%

2-3%

18-20%

Source: State of the Middle Market discussion

Attractive Lending Market Likely To Continue As Banks and Irrational Competitors Not Likely To Return for a Significant Period of Time. When asked about competition in the middle market our speakers discussed the massive fallout of investors previously in the market place. Many of the large commercial banks are out of the market including La Salle, Wachovia and Bank of America. Only Wells Fargo is left lending to the middle market through its Wells Foothill subsidiary. All of the CLOs and debt vehicles financed with CLO debt are gone (Cratos, GSC Group and many more). Hedge funds that were buying the bank loan market and leveraging the balance sheet with repo debt are completely gone. Several large BDCs (ACAS & ALD) are out of the market. Management said the list of remaining competitors is much easier to list. There are a few healthy regional banks (US Bank mentioned), a few healthy BDCs, Golub Capital, GE Capital is lending again, and TCW and Oaktree are active in the upper-end of the middle market. All speakers agreed that the remaining competitors are all rational investors and there are enough opportunities for everyone without the need to become aggressive on pricing. Finally, expectations were that the attractive lending environment will remain for a while as irrational competitors (hedge funds & CLOs) will not receive funding for a long time and increased regulations on banks will prohibit them from becoming aggressive in the middle market space. One additional interesting tidbit is that the upper-end of the middle market is currently less competitive than the lower-end while historically, the opposite is true. As one speaker explained, "it's much easier to find someone today that can make a $20 million investment to fund a smaller investment than to find someone who can make a $100 million investment in a larger investment. The pipeline For New (Primary) Investment Opportunities Is Building Rapidly And 4Q09 Should See Significantly Higher M&A Volumes. M&A activity is building with buyer and seller expectation convergence as well as rational debt pricing being made available (rational for both lenders and equity investors). Earlier this year when the secondary markets were yielding 20-30%, private equity investors could not effectively utilize debt for new investments with those types of yields; however, our PE speaker, Charles Brizius of TH Lee, stated that current yields mentioned above for senior and mezz debt are very workable in new investment structures. To quote Mr. Brizius, "this is an environment where both the lender and equity sponsor can win". This is a noticeable difference from the NYC dinner where M&A activity still had many road blocks and our speakers believe that 4Q09 will see "significantly higher M&A
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Specialty Finance volumes".

September 18, 2009

A Massive $800 Billion In Debt Is Needed In The Next Two Years Met By New Capital And "Amend & Extend". This Should Extend The Attractive Lending Environment. There is a $300 billion wall of debt coming due in the next two years that will need to be addressed. In addition there is another $500 billion of private equity capital that needs to be invested or it must be returned to the LP's (which isn't going to happen). Based on current structures where equity invests 50% and debt is 50% this implies that an additional $500 billion of debt is needed to fund the private equity investments. First, our panel believes that the $300 billion of debt coming due will be handled outside of the courts through amending and extending the loans. While this could lead to some difficulty for debt investors that need repayments (this is becoming less an issue as liquidity is building on bank balance sheets) for those investors without liquidity issues this is a perfectly fine result as they have the opportunity to re-price the loans to current market rates and significantly improve mark-to-market values. In addition, our PE speaker noted that the 10-15 largest deals account for nearly half of the $300 billion coming due. There was a thought that perhaps given the recent run in the equity markets, it could be possible to spin back out these large investments as public companies and using the proceeds to delever (wiping out the PE sponsor investment). As for the remaining $500 billion of debt needed to fund PE buyout activity, the panel was confident that liquidity will flow towards where there is opportunity and these deals will get funded; however the bottom line is a belief that the attractive investment environment will continue for some time. Final Tidbit: The Panel Was Unanimous in the View That Public Equity Markets Have Likely Overshot the Fundamental Economic Trends and the Credit Markets are Lagging the Equity Euphoria. Although this final point has little to do with the state of the middle market, we thought it was interesting that all three speakers believed the public equity markets were likely ahead of the economic reality over the next year. The unanswered question is whether capital will continue to come off the sidelines to support the market until the fundamentals grow into the market multiple...or will there be a pull-back? Unfortunately our dinner didn't solve that one.

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Specialty Finance Important Disclosures and Certifications

September 18, 2009

I, Greg Mason, certify that the views expressed in this research report accurately reflect my personal views about the subject securities or issuers; and I, Greg Mason, certify that no part of my compensation was, is, or will be directly or indirectly related to the specific recommendation or views contained in this research report. I, Troy Ward, certify that the views expressed in this research report accurately reflect my personal views about the subject securities or issuers; and I, Troy Ward, certify that no part of my compensation was, is, or will be directly or indirectly related to the specific recommendation or views contained in this research report. Stifel, Nicolaus & Company, Inc.'s research analysts receive compensation that is based upon (among other factors) Stifel Nicolaus' overall investment banking revenues. Our investment rating system is three tiered, defined as follows: BUY -We expect this stock to outperform the S&P 500 by more than 10% over the next 12 months. For higher-yielding equities such as REITs and Utilities, we expect a total return in excess of 12% over the next 12 months. HOLD -We expect this stock to perform within 10% (plus or minus) of the S&P 500 over the next 12 months. A Hold rating is also used for those higher-yielding securities where we are comfortable with the safety of the dividend, but believe that upside in the share price is limited. SELL -We expect this stock to underperform the S&P 500 by more than 10% over the next 12 months and believe the stock could decline in value. Of the securities we rate, 36% are rated Buy, 60% are rated Hold, and 4% are rated Sell. Within the last 12 months, Stifel, Nicolaus & Company, Inc. or an affiliate has provided investment banking services for 6%, 6% and 3% of the companies whose shares are rated Buy, Hold and Sell, respectively. Additional Disclosures Please visit the Research Page at www.stifel.com for the current research disclosures applicable to the companies mentioned in this publication that are within Stifel Nicolaus' coverage universe. For a discussion of risks to target price please see our stand-alone company reports and notes for all Buy-rated stocks.

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Specialty Finance

September 18, 2009

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