This document summarizes the use of the private cost of capital model for valuing privately held companies. It discusses that privately held companies obtain capital from private rather than public markets, so their cost of capital should be based on expected returns in private capital markets. The Pepperdine Private Capital Markets Project surveys private capital providers to determine expected returns by type of capital and investment size. These expected returns are used to estimate cost of capital for privately held firms according to the private capital they would likely obtain.

1. A P R O F E S S I O N A L D E V E L O P M E N T J O U R N A L f o r t h e C O N S U LT I N G D I S C I P L I N E S
v a l u a t i o n
•
Using the Private Cost of Capital Model
•
By John K. Paglia, PhD, CFA, CPA; and Robert T. Slee, CBA, CM&AA
U
sing public company stock price return data to estimate discount rates Given the answers to these questions, it
for privately held companies has become increasingly complex over the then seems apparent that Shannon Pratt is
past decade. Definitive answers to fundamental questions surrounding correct in saying that cost of capital is the
the topic of adjusting public returns to apply to privately held compa- expected rate of return that the relevant
nies remain in debate. Among those questions that consume a considerable amount market requires in order to attract funds to
a particular investment.2 In other words,
of intellectual resources and bandwidth, lion and $100 million.1 It appears the cost of capital estimates for privately held
in no particular order: uncertainty surrounding answers to the companies should be taken from the mar-
questions above has created a lack of kets in which they raise capital.
• What is an appropriate size premium? confidence with the application of pub- In an earlier article,3 we made the ar-
• How much is a discount for lack of licly traded stock data to privately held guments for using a model that captured
marketability? companies. This raises an even more discount rates from the markets in which
• What is the difference between mar- fundamental question: privately held companies fund based
ketability and liquidity, and how do upon actual investment checks written
I determine an adjustment for each? Should we be using publicly traded by the providers of that capital. We also
• How do I adjust for a controlling in- company stock return data as the unveiled the private cost of capital model
terest? primary basis for estimating cost of to be used to estimate discount rates for
• Should I use a historical equity risk pre- capital for privately held companies? businesses that are not publicly traded.4
mium or one that is forward-looking? The purpose of this article is to offer
• Is Beta or Total Beta more appropri- To help answer that question, we re- guidance on the application of the pri-
ate when using the capital asset pric- flect on the following: vate cost of capital model and to address
ing model? questions that have arisen in regard to
• Should I tax-effect or not? • Do privately held firms obtain capi- the usage of this model.
tal from the public markets? [No.]
The complexity and confusion is re- • Do the majority of privately held PRIVATE CAPITAL ACCESS
flected in recent survey data. In fact, companies go public? [No.] DRIVES DISCOUNT RATE
just 39 percent of business appraisers • Do we have robust sources for ob- The broad categories of capital avail-
reported a level of comfort with us- taining capital in the private capital able in the private capital markets are
ing public data to estimate discount markets? [Yes.] called capital types. The capital types
rates for privately held companies in • Do these capital sources price risk in
2 Valuing a Business, 5th Edition, by Shannon P.
the range of $5 million to $25 million their particular segments? [Yes.] Pratt, McGraw-Hill, 2008, Page 182.
in revenues, while 60 percent indicated • Is it possible to learn what these return 3 Robert T. Slee, Private Capital Markets:
Valuation, Capitalization, and Transfer of Private
some level of comfort when estimating expectations are by segment? [Yes.]
Business Interests, John Wiley & Sons, 2004.
cost of capital for privately held com- 4 Robert T. Slee and John K. Paglia, “The Private
panies with revenues between $25 mil- 1 Pepperdine Private Capital Markets Project, Cost of Capital Model,” The Value Examiner,
Summer 2010 Report (http://bschool.pepperdine. NACVA, March/April 2010.
edu/privatecapital).
The Value Examiner May/June 2011 7

2. A P R O F E S S I O N A L D E V E L O P M E N T J O U R N A L f o r t h e C O N S U LT I N G D I S C I P L I N E S
are bank lending, asset-based lending,
mezzanine financing, private equity,
factoring, angel investment, and ven-
ture capital. These capital types corre-
spond to institutional capital offerings
in the marketplace.
When investments are made or credit
is extended in the private capital markets,
it is with a certain return expectation. That
is, capital providers will write investment
checks or grant credit to those companies
that offer the best expected returns given
risk appetite, size preferences, industry
preferences, geographical considerations,
and other unique influences.
We stress the importance of using
expected rates of return. First, this re-
turn is the expected rate of return the
provider would accord the investment at
hand, given the provider’s capital type.
In other words, capital providers require Source: Pepperdine Private Capital Markets Project Winter 2011 Report, December 2010.
a certain “all-in” return to compensate
them for taking the risk of extending the
credit or making the investment. This ex- ing future cash flows with historical costs simultaneous, and ongoing investiga-
pected return is the effective cost to the of capital may result in significant errors. tion of the decision-making behavior
borrower or investee as it is inclusive of Third, because of the limited amount of private capital providers. The survey
various transactions costs. For example, of capital deployed and constrained re- specifically examines the activity and
the borrower may incur legal, brokerage, sources in the capital allocation process, behavior of senior (cash flow) lenders,
environmental, and other costs in effect- investors will frequently invest capital asset-based lenders, factors, mezzanine
ing the transaction. These costs are con- at an expected return that exceeds their funds, private equity groups, venture
sidered when calculating an effective or hurdle rate. So in order for companies capital firms, and angel investors, in ad-
all-in cost to the borrower or investee. to obtain capital in these markets, they dition to other groups involved in the
Second, cost of capital should be must transact with the capital sources at private capital markets including busi-
based on expected rather than realized the providers’ expected return levels, not ness owners, intermediaries, limited
returns, even though there are often hurdle rates or required rates of return. partners, and appraisers.
substantial differences between the two Expected returns for newly issued The Pepperdine PCOC survey investi-
rates. Expected returns are used because investment or credit checks can be ob- gated, for each major private capital type,
capital providers offer credit and struc- tained through direct inquiry. One such the important benchmarks that must be
ture deals based on what they expect to source of this information is the Pep- met in order to qualify for capital,, how
receive from the investment. Therefore perdine Private Capital Markets Project much capital is typically accessible, and
expected returns on new investments or private cost of capital surveys. what the expected returns are for ex-
credit most accurately reflect the eco- tending capital in the current economic
nomics of the private capital markets. PEPPERDINE SURVEyS environment. Four survey cycles have
This forward-looking assessment of all- The Pepperdine private cost of capi- been completed thus far. The first survey
in capital costs is essential when evaluat- tal (PCOC) survey project, launched report, based on 627 responses from pri-
ing future benefit streams. Simply assess- in 2007, is the first comprehensive, vate capital market participants, was pub-
8 May/June 2011 The Value Examiner

3. A P R O F E S S I O N A L D E V E L O P M E N T J O U R N A L f o r t h e C O N S U LT I N G D I S C I P L I N E S
TABLE 1: Private Cost of CaPital Data lished in August 2009. The fourth report,
(gross annualizeD rates %) which yielded nearly 2,000 responses, was
published in December 2010.5 The next
Capital Type / Segment 1st Quartile Median 3rd Quartile
report will be released in May 2011. The
Bank ($1M Cash flow loan) 5.4 6.5 7.1 web-based surveys are administered semi-
Bank ($5M Cash flow loan) 5.0 6.0 6.8 annually, each having 25 to 50 questions.
Bank ($10M Cash flow loan) 4.5 5.5% 6.6 In these surveys, return expectations
are captured from the various segments
Bank ($25M Cash flow loan) 3.8 5.0 7.0
of the private capital markets along with
Bank ($50M Cash flow loan) 3.8 5.0 6.3 the credit boxes, which are the criteria
Bank ($100M Cash flow loan) 3.6 4.8 6.1 prospects must display in order to qual-
aBl ($1M loan) 6.5 12.0 18.0 ify for an investment. Return expecta-
5.5 7.0 10.0
tions can be plotted on a graph, which,
aBl ($5M loan)
in the case of using the Pepperdine sur-
aBl ($10M loan) 4.4 5.5 7.4
veys, is the Pepperdine Private Capital
aBl ($25M loan) 3.0 3.5 4.5 Market Line (PPCML). This graph con-
aBl ($50M loan) 3.0 3.3 4.0 tains seven major capital types, and it
aBl ($100M loan) 2.8 3.0 3.5 appears on page 8.
The PPCML encompasses various
Mezz ($1M eBitDa) 18.0 20.0 22.0
capital types in terms of the provider’s
Mezz ($5M eBitDa) 17.0 19.5 22.1
all-in expected returns. The PPCML is
Mezz ($10M eBitDa) 17.3 18.9 20.0 described as median, pre-tax expected
Mezz ($25M eBitDa) 17.9 18.5 19.0 returns for institutional capital provid-
Peg ($1M eBitDa) 25.0 30.0 30.8 ers. The PPCML is stated on a pre-tax
basis, both from a provider and from a
Peg ($5M eBitDa) 25.0 30.0 30.0
user perspective. In other words, capi-
Peg ($10M eBitDa) 24.5 30.0 31.3 tal providers offer deals to the market-
Peg ($25M eBitDa) 25.0 28.0 30.0 place on a pre-tax basis. For example, if
Peg ($50M eBitDa) 22.0 25.0 30.0 a private equity investor requires a 25
35.0 40.0 50.0
percent return, this is stated as a pre-
vC (startup)
tax return. Also, the PPCML does not
vC (early stage) 30.0 35.0 45.0
assume a tax rate to the investee, even
vC (expansion) 20.0 30.0 40.0 though some of the capital types use in-
vC (later stage) 20.0 30.0 35.0 terest rates that generate deductible in-
angel (seed) 30.0 50.0 100.0 terest expense for the borrower. Capital
types are not tax-effected because many
angel (startup) 30.0 40.0 75.0
owners of private companies manage
angel (early stage) 25.0 35.0 50.0
their company’s tax bill through vari-
angel (expansion) 20.0 30.0 40.0 ous aggressive techniques. It is virtually
angel (later stage) 20.0 30.0 40.0 impossible to estimate a generalized ap-
factor $100K/mo. 58.5 74.5 88.2 propriate tax rate for this market.
Table 1 contains the expected return
factor $250K/mo. 48.8 58.5 74.5
data used to generate the PPCML. This
factor $500K/mo. 48.8 48.8 67.2
factor $1M/mo. 35.4 41.2 53.6 5 Pepperdine Private Capital Markets Project
Survey Report, December 2010, John K. Paglia,
factor $5M/mo. 31.3 32.7 35.4 http://bschool.pepperdine.edu/privatecapital.
Source: Pepperdine Private Capital Markets Project Winter 2011 Report, December 2010.
The Value Examiner May/June 2011 9

4. A P R O F E S S I O N A L D E V E L O P M E N T J O U R N A L f o r t h e C O N S U LT I N G D I S C I P L I N E S
table outlines median (50th percentile)
TABLE 2: senior (Cash flow) lenDer CreDit analysis
returns, 1st quartile (25th percentile),
BenChMarKs (fall 2010)
and 3rd quartile (75th percentile) ex-
pected returns by capital type and for
various segments of each. For instance, Financial Indicator Average Approval Importance
according to the table, a $10 million Borrower Limits Score (0-4)
bank loan based upon cash flow has a Current ratio 1.4 1.3 1.7
median all-in rate of 5.5 percent, while senior debt service coverage 1.3 1.3 3.2
the median cost of capital for a private (or fCC) ratio
equity investment to a company with
total debt service coverage 1.3 1.3 3.7
approximately $50 million in earnings
(or fCC) ratio
before interest, taxes, depreciation, and
amortization (EBITDA) is 25.0 percent. senior debt to cash flow 2.5 3.0 3.0
It should be noted that each capital total debt to cash flow 3.0 3.5 3.2
type has its own rules regarding capital Debt to net worth 2.0 2.4 2.5
access. These rules are important for cre-
revenue growth rate 3.0% 2.1% 1.8
ating a capital structure for our subject
company. Specifically, the major “rules”
utilized by banks, asset-based lenders,
mezzanine funds, private equity, venture TABLE 3: senior leverage MultiPles for ManufaCturing
capital, angel investors, and factors are CoMPanies (fall 2010)
identified in the following sections. Manufacturing EBITDA 1st Quartile Median 3rd Quartile
$1M eBitDa 1.3 1.3 2.0
SENIOR CASH FLOW LENDERS
Senior cash flow lenders generally $5M eBitDa 2.1 2.5 3.0
lend up to an amount that is primar- $10M eBitDa 2.4 2.5 3.0
ily a function of an EBITDA multiple
$25M eBitDa 2.6 3.0 3.0
after meeting fixed charge or debt ser-
vice coverage threshold tests. The vari- $50M eBitDa 2.5 3.0 3.0
ous ratios, their limits, and their im- $100M eBitDa 2.3 3.0 3.2
portance are outlined in Table 2. For
instance, the median approval limit for
the senior debt service coverage ratio
is 1.3x. More detailed information on ASSET-BASED LENDERS ABLs establish certain thresholds
these ratios can be found in the most Asset-based lenders (ABLs) generally for amount of loan based on advance
recent Pepperdine Private Capital lend against certain assets the company rates, which vary by collateral class
Market Project reports. owns up to certain limits or advance and quality of collateral. For instance,
The loan amounts extended are gen- rates. A company will generally choose the loan limit for accounts receivable
erally based on a multiple of historical asset-based lending for any of the fol- asset backed loans will generally be
recast (or adjusted) EBITDA. Median lowing three reasons: they don’t qualify between 80 and 85 percent of the face
senior leverage EBITDA multiples for for a loan against cash flow, they have an value of those receivables. High qual-
a manufacturing company, for instance, asset backed borrowing capacity that ex- ity inventory will produce a loan size
range from 1.3x for a company produc- ceeds a loan amount obtainable from its of approximately 55 to 60 cents on the
ing $1 million in EBITDA to 3.0x for a cash flow, or if the all-in rate is cheaper dollar at an orderly liquidation value.
company with $100 million in EBITDA than that offered by a cash flow based Other classes of collateral produce dif-
(see Table 3). loan. As a result, ABLs may also hold a ferent advance rates. These are noted
senior position in the capital structure. in Table 4.
10 May/June 2011 The Value Examiner

5. A P R O F E S S I O N A L D E V E L O P M E N T J O U R N A L f o r t h e C O N S U LT I N G D I S C I P L I N E S
As a general rule, but not in all cases,
TABLE 4: asset-BaseD lenDer aDvanCe rates (fall 2010)
mezzanine funds will invest debt after it
has been determined how much senior
Collateral type typical loan upper limit
debt can be raised, since senior debt is
(Median advance %) (Median advance %)
commonly the cheaper source. Mezza-
Marketable securities 80 90 nine funds will then invest an amount
that brings the investee company up to
accounts receivable 80 85
the specified threshold. As an example,
inventory - low Quality 25 40 the median maximum mezzanine in-
inventory - intermediate Quality 40 50 vestment threshold is 4.0x EBITDA for
inventory - high Quality 55 60 a company with approximately $10 mil-
lion in EBITDA. If we look back at cash
equipment 60 80
flow lender size limits, we find a 2.5x
real estate 60 70
EBITDA threshold for companies of
land 50 50 approximately $10 million in EBITDA.
Because a mezzanine fund will lend up
to a total limit of 4.0x, there remains
TABLE 5: asset-BaseD lenDer CreDit analysis BenChMarKs 1.5x EBITDA in lending capacity. So
(fall 2010) the mezzanine fund can deploy 1.5x
EBITDA in loan amount to hit that 4.0x
threshold. Other lending thresholds,
Financial Indicator Average Approval Importance
expressed in EBITDA multiples, can be
Borrower Limits Score (0-4)
found in Table 6 (page 12).
Similar to cash flow and asset-based
Current ratio 1.0 1.0 1.1
lenders, mezzanine investors also focus
total debt service coverage ratio 1.2 1.0 2.6 on certain financial indicators to deter-
total debt to cash flow 3.5 3.8 2.4 mine if a company qualifies for invest-
Debt to net worth 2.1 2.5 2.1 ment. Among those that are considered
revenue growth rate 1.1% 1.0% 1.5
most important are senior debt service
coverage ratio, funded debt service cov-
erage ratio (based upon amount funded
by a particular provider), and senior
debt to cash flow ratio. Table 7 (page 12)
Because of the pledged collateral, ABLs are slightly less concerned than cash flow shows the various indicators along with
lenders about the various ratios that typically guide an evaluation of credit access. their importance scores.
The most important ratio is the debt service coverage ratio, but at an importance
level of 2.6 it is significantly less weighty than the 3.7 rating reported by cash flow PRIVATE EQUITy
lenders. Table 5 shows the various indicators along with their importance scores. Private equity groups generally
make equity investments in companies
MEzzANINE that are generating a positive cash flow
Mezzanine funds invest in companies that are generating a positive cash of at least $1 million EBITDA on a re-
flow of at least $1 million on a recast basis. A large percentage of mezzanine cast basis. A large percentage of private
fund investments get deployed in manufacturing, services, and healthcare equity fund investments get deployed
businesses. The amount a mezzanine fund is willing to invest depends largely in manufacturing, services, and health-
upon a multiple of EBITDA, which is generally expressed on a historical and care businesses. Company valuations
recast basis. are largely based on a multiple of recast
The Value Examiner May/June 2011 11

6. A P R O F E S S I O N A L D E V E L O P M E N T J O U R N A L f o r t h e C O N S U LT I N G D I S C I P L I N E S
attractive and addressable markets,
TABLE 6: Mezzanine funDs lenDing CaPaCity
significant competitive advantages,
(eBitDa Multiples) By CoMPany eBitDa size
and scalable and capital-efficient busi-
ness models. Table 10 shows those and
$1M $5M $10M $25M other factors along with their weights
Statistic EBITDA EBITDA EBITDA EBITDA and overall scores.
1st Q 2.9 3.5 3.5 4.4 Venture capital funds report that
Median 3.5 3.5 4.0 4.8 median company values at time of in-
3rd Q 4.1 4.0 4.0 5.0
vestment range from $3 million for
seed/startup companies to $35 million
for later-stage investments. Additional
details can be found in Table 11.
TABLE 7: Mezzanine investMent analysis BenChMarKs (fall 2010)
ANGEL
Angel investors invest in high-
Financial Indicator Average Approval Importance
growth companies that span the range
Borrower Limits Score (0-4)
from startups to later-stage companies,
Current ratio 2.0 1.3 2.9
but most of their focus is on the seed,
senior debt service coverage ratio 1.6 1.3 3.3 startup, and early stages. Angel inves-
funded debt service coverage ratio 1.3 1.2 3.4 tors report median company values
total debt service coverage ratio 1.3 1.2 2.7 at time of investment of $1 million
for seed investments, $2 million for
senior debt to cash flow 2.5 3.0 3.4
startup companies, and $3 million for
total debt to cash flow 3.5 4.0 1.4 early stage investments. Companies
Debt to net worth 2.1 2.3 2.4 that typically qualify for angel invest-
revenue growth rate 10% 2.5% 1.3 ments have great growth prospects,
top-tier management teams, attractive
and addressable markets, significant
competitive advantages, and scalable
EBITDA. Median deal multiples reported range from 4x EBITDA for companies and capital-efficient business models.
with approximately $1 million in EBITDA to 7.5x for companies with approxi- These and other factors along with
mately $50 million in EBITDA. These deal multiples and others can be located in their weights and overall scores can be
Table 8 (page 13). located in Table 12 (page 14).
Private equity funds consider many factors when evaluating an investment
opportunity. In terms of importance of various attributes, aside from having posi- FACTORS
tive cash flow and positive growth prospects, they report that the management Factors generally provide capital
team and future prospects of the company are among the most important con- against accounts receivable assets. Gen-
siderations when deciding to write an investment check. They also indicate that erally as long as a company has accounts
historical operating performance and a general lack of customer concentrations receivable that are collectable with a high
are items that guide their investment analysis. Other factors along with their degree of certainty, a company can ob-
weights and overall scores can be located in Table 9. tain capital from factors. Median advance
rates range from 80 to 90 percent where
VENTURE CAPITAL the advanced amounts generally increase
Venture capital as an asset class invests in high-growth companies that span with increases in monthly volume. Cur-
the range from startups to later-stage companies. Companies that typically qual- rent median advance rates are shown in
ify for venture capital have great growth prospects, top-tier management teams, Table 13 (page 14).
12 May/June 2011 The Value Examiner

7. A P R O F E S S I O N A L D E V E L O P M E N T J O U R N A L f o r t h e C O N S U LT I N G D I S C I P L I N E S
TABLE 8: Private eQuity grouP Deal MultiPles (fall 2010)
Company Size 1st Quartile Median 3rd Quartile
$1M eBitDa 3.9 4.0 5.3
$5M eBitDa 4.5 5.0 5.7
$10M eBitDa 5.0 6.0 7.0
$25M eBitDa 5.5 6.0 7.8
$50M eBitDa 7.5 7.5 8.0
TABLE 9: Private eQuity grouP iMPortant faCtors When investing (fall 2010)
Of little Moderately Very Score
Factors Unimportant importance important Important important (0–4)
firm size 6.0% 10.3% 46.2% 29.9% 7.7% 2.2
Customer concentrations 0.8% 3.4% 13.4% 42.0% 40.3% 3.2
Market leadership 0.8% 5.9% 33.9% 40.7% 18.6% 2.7
historical operating performance 0.0% 3.4% 13.6% 53.4% 29.7% 3.1
industry sector 0.9% 5.1% 22.2% 41.9% 29.9% 2.9
future prospects of company 0.0% 0.0% 3.4% 22.0% 74.6% 3.7
Management team 0.0% 0.0% 7.2% 25.3% 67.5% 3.6
TABLE 10: venture CaPital iMPortant faCtors When investing (fall 2010)
Of little Moderately Very Score
Factors Unimportant importance important Important important (0–4)
top tier management teams 0.0% 2.0% 2.0% 36.7% 59.2% 3.5
attractive addressable markets 0.0% 0.0% 6.1% 38.8% 55.1% 3.5
significant competitive advantages 0.0% 2.0% 4.1% 34.7% 59.2% 3.5
investment syndicates with aligned interests 2.1% 8.3% 25.0% 33.3% 31.3% 2.8
scalable and capital efficient business models 0.0% 0.0% 4.1% 36.7% 59.2% 3.6
Deals that are not widely shopped 4.2% 12.5% 54.2% 22.9% 6.3% 2.1
TABLE 11: venture CaPital: CoMPany value at tiMe of investMent (fall 2010)
Startup/Seed Early stage Expansion Later stage
Statistic ($ millions) ($ millions) ($ millions) ($ millions)
1st quartile 2.0 4.0 12.3 25.0
Median 3.0 8.0 20.0 35.0
3rd quartile 5.0 10.5 33.5 75.0
The Value Examiner May/June 2011 13

8. A P R O F E S S I O N A L D E V E L O P M E N T J O U R N A L f o r t h e C O N S U LT I N G D I S C I P L I N E S
TABLE 12: angel investors iMPortant faCtors When investing (fall 2010)
Of little Moderately Very Score
Factor Unimportant importance important Important important (0–4)
top-tier management teams 2.5% 0.0% 7.5% 25.0% 65.0% 3.5
attractive addressable markets 0.0% 0.0% 2.5% 49.4% 48.1% 3.5
significant competitive advantages 0.0% 0.0% 7.5% 41.3% 51.3% 3.4
investment syndicates with aligned interests 6.3% 15.2% 38.0% 30.4% 10.1% 2.2
scalable and capital efficient business models 1.3% 0.0% 16.3% 42.5% 40.0% 3.2
Deals that are not widely shopped 12.7% 29.1% 30.4% 20.3% 7.6% 1.8
no vCs involved 26.7% 35.6% 13.3% 22.2% 2.2% 1.4
Where:
TABLE 13: faCtor MeDian aDvanCe rates % (fall 2010) • N is the number of sources of capital.
Monthly volume 1st quartile Median 3rd quartile • MVi is the market value of all out-
$25,000 80.0 80.0 89.0 standing securities i.
$50,000 80.0 80.0 90.0 • CAPi equals the median expected
return for capital type i.
$100,000 80.0 80.0 86.0
• SCAPi equals the specific CAP risk
$250,000 80.0 80.0 86.0 adjustment for capital type i.
$500,000 80.0 80.0 85.0
$1M 80.0 80.0 85.0 PCOC depends on private cost of
80.0 80.0 85.0
debt (PCOD), private cost of equity
$5M
(PCOE), and private cost of preferred
$10M 80.0 80.0 87.5
(PCOP) where applicable.
$25M 79.8 82.5 90.0
$50M 78.5 85.0 90.0 There are four steps to determining
$100M 87.5 90.0 90.0 PCOC.6
> $100M 90.0 90.0 95.0
1. To determine the appropriate capi-
tal types by which to compare, re-
PRIVATE COST OF CAPITAL MODEL view the credit boxes described in
A relevant private discount rate model should enable the user to determine the the most current Pepperdine survey.
expected rate of return that the market of private capital providers requires in order Select the appropriate median CAP
to attract funds to a particular subject or investment. The PCOC model yields such from the survey results for each
a discount rate by positioning the user into the decision-making process of private qualifying capital type.
capital providers. We created this model to empower users of private capital market 2. Determine the market value of each
data, such as from the Pepperdine capital market surveys, to derive a discount rate capital type.
that is generated from empirical data. 3. Apply a specific CAP risk adjust-
ment (SCAP) to the selected median
The PCOC model is as follows: capital type based on a comparison

∑ MVi 6 Steps have been consolidated from the five
PCOC = (CAPi + SCAPi ) x initially indicated in “The Private Cost of Capital
∑

Model” (2010) by Slee and Paglia.
i=1 MVj
i=1
14 May/June 2011 The Value Examiner

9. BEWARE!
of subject results to the appropriate survey credit box. Use
first and third quartile returns as a guide to this adjustment.
4. Calculate the percentage of capital structure for each CAP.
Multiply each weight of capital structure component by its
CAP. Add the individual percentages to derive PCOC.
The following example demonstrates the model’s usage.
Example 1: Cost of Capital for PrivateCo Assuming Known
Value and Optimal Capital Structure Already in Place
PrivateCo’s discount rate will now be derived below.7 To deter-
mine the appropriate capital types by which to compare, review
the credit boxes described in the appropriate Pepperdine survey.8
Select the appropriate median CAP from the survey results.
PrivateCo, reporting adjusted EBITDA of $5 million, has a
5 Things You
relatively simple capital structure. CAP is found for each capital
type from a recent Pepperdine survey. For existing debt, in lieu of Don’t Want To
Do When You
using the empirical data from the Pepperdine survey, the analyst
may calculate the expected (all-in) return directly from the loan
agreement.9 Table 14 (page 17) shows the market value capital
structure along with the CAPs.
By reviewing the PPCML and associated data, the CAP for
Value Equipment...
PrivateCo’s term loan and equity is 6.5 percent and 30 percent, 1. Don’t rely on the word of the owner.
respectively. The equity CAP is 30 percent, the same number as 2. Don’t rely on the depreciation schedule.
shown for equity on the PPCML, because PrivateCo fits within 3. Don’t rely on book value.
the “$5M EBITDA” category of the Pepperdine survey. 4. Don’t you guess.
5. Don’t rely on the word of an auctioneer or dealer who
Next we focus on a specific capital type (SCAP) risk adjust-
is not Certified. They may have another agenda.
ment for debt to the selected median capital type based on a com-
“
parison of subject results to the appropriate survey credit box. “
ALL of these methods are inaccurate
Use first and third quartile returns as a guide to this adjustment. and filled with a tremendous amount of risk.
To determine the SCAP risk adjustment, the appraiser must Not to mention these methods provide for an
compare surveyed and subject credit boxes for each capital type. unsubstantiated and skewed valuation!
Table 15 shows this comparison for the term loan.
The surveyed results represent the qualifying minimum (or If you are a Certified Machinery & Equipment
maximum) threshold for loan approval. For example, in order Appraiser (CMEA), you’ll learn how to determine
to make a loan, lenders require a minimum current ratio of 1.3, and report equipment values. You will be able to
minimum fixed charge coverage of 1.3, and so on as a median. reduce your risk of liability and provide the
substantiation you need to deliver a defensible
Not all credit box characteristics are considered equally im-
Certified Equipment Appraisal that will withstand
portant, as the “Very Important” and “Score” columns indicate. scrutiny. Not to mention, you’ll also enjoy increased
business opportunities!
7 PrivateCo is the fictitious company described in Slee’s Private Capital Markets
book. The market valuation and other numbers specific to PrivateCo are taken from Isn’t it time that you deliver a defensible business
that book. valuation which involves machinery and equipment
8 With respect to the effective valuation date. that will withstand scrutiny? Call us today, you’ll
9 This may be done if the debt was obtained at a point in time recent to the date be glad that you did!
of valuation, was at arm’s length, and reflective of market conditions. Furthermore it
may be relevant only if the capital structure, financial position, or business prospects
have not changed materially since it was obtained.
Toll Free (866) 632-2467
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The Value Examiner

10. A P R O F E S S I O N A L D E V E L O P M E N T J O U R N A L f o r t h e C O N S U LT I N G D I S C I P L I N E S
For instance, current ratio and debt to A. PEGs are rightly concerned The next step is to determine Pri-
net worth are less important variables about customer concentrations. Pri- vateCo’s CAP by capital type, as shown
to the lending decision than total debt vateCo has no single customer that in Table 17 (page 19).
service ratio and senior debt to EBIT- represents more than 20 percent of an- By comparing survey results to Pri-
DA. The Pepperdine survey asked re- nual sales. The top 10 customers rep- vateCo’s actual or expected results,
spondents to score their responses on resent 40 percent of annual sales. The SCAP can be determined for PCOD and
a four-point scale. Only senior fixed top 50 customers represent 70 percent PCOE. PrivateCo compares favorably
charge coverage, total fixed charge of sales. This diversity of customers and to survey term debt results, as shown
coverage, senior debt service, and to- lack of customer concentration would in Table 17, but the loan size is smaller
tal debt service scored a 3.0 or above. be viewed as a positive by PEGs. than the $1 million minimum. Thus,
For purposes of deciding PCOD SCAP, B. PEGs are less concerned than PCOD SCAP is 0.6 percent, which is the
greater weight should be assigned to all of the other categories about mar- number needed to convert CAP to the
these variables. ket leadership. PrivateCo is not viewed 3rd quartile survey result of 7.1 percent.
As the last column in Table 15 as a market leader in its space. Rather, In other words, PrivateCo can expect to
shows, PrivateCo compares favorably it is considered a well run, follow-the- pay an all-in PCOD of 7.1 percent.
against median results for all metrics. leader company. Deriving PCOE SCAP requires
Since PrivateCo generates a high level C. Historical operating perfor- comparing surveyed results from pri-
of EBITDA relative to investment in mance is moderately important to pri- vate equity groups to PrivateCo’s actual
the business, its leverage ratios are out- vate equity investors. PrivateCo has a and expected results. As this illustra-
standing, as witnessed by a low total fairly stable operating performance over tion shows, PrivateCo would likely be
debt to EBITDA of 0.6, which is sub- the past few years. viewed by PEGs as an average candi-
stantially lower than median survey D. PEGs view industry sector as date. Thus, PCOE SCAP is 0, and PCOE
results. Further, PrivateCo’s coverage moderately important. PrivateCo op- CAP is 30 percent.
ratios indicate low debt in the business erates in a sector with relatively long Next we calculate the percentage
yet high profitability. PCOD SCAP will periods of stability. This sector is not of capital structure for each CAP and
reflect that PrivateCo’s financial results expected to change appreciably in the add the individual percentages to de-
compare favorably to 1st quartile sur- foreseeable future. rive PCOC. Table 18 shows PrivateCo’s
vey responses. E. PEGs are mostly concerned with PCOC calculation, assuming no taxes.
The next step in determining PCOC the future prospects of a company. Pri- In this example, PrivateCo has a
is to derive PCOE SCAP. This is accom- vateCo will perform well into the fu- pre-tax private cost of capital of 29
plished by comparing surveyed private ture, but not at a breakneck pace. This percent (rounded).
equity group expectations to PrivateCo’s is mainly due to conservative policies The next example determines PCOC
results. Table 16 makes this comparison. set by the owner of PrivateCo. given a more complicated capital structure.
The surveyed results represent Pri- F. PrivateCo’s management team is
vate Equity’s credit box; that is, the cri- seasoned, but mainly home grown. The Example 2: Arranging a Capital
teria that prospects must display in or- average tenure of direct reports to the Structure and Calculating PCOC
der to qualify for investment. PrivateCo owner is more than 20 years. While this for Middle Market Manufacturing
is expected to perform well in revenue offers stability, it may present a problem
and EBITDA growth when compared to if a PEG invested in the company and Next we calculate the cost of capital
median expectations from the winter/ wished to make major changes. for Middle Market Manufacturing, Inc.
spring 2010 survey. However, PrivateCo (MMM). MMM has recast EBITDA of
is not expected to surpass 3rd quartile In summary, PrivateCo qualifies for $5 million, and it is determined that
expectations in these areas. private equity investment, but would similar manufacturing companies are
Private equity groups also scored likely be viewed as an average performer, selling at deal multiples of 7x EBITDA.
various investment measures. Private- with average expectations. For this rea- This produces a market value of $5 mil-
Co compares as follows: son, PCOE SCAP is zero. lion EBITDA x 7 = $35 million (ignor-
16 May/June 2011 The Value Examiner

11. A P R O F E S S I O N A L D E V E L O P M E N T J O U R N A L f o r t h e C O N S U LT I N G D I S C I P L I N E S
TABLE 14: PrivateCo CaPital struCture anD CaPs
Capital Type Market Value PPCML CAP
term loan (cash flow loan) $500,000 6.5%
equity $13,700,000 30.0%
TABLE 15: CoMParison of surveyeD anD PrivateCo terM loan CreDit Boxes
Term Loan
Pepperdine Survey
1st Quartile Median 3rd Quartile Very Import. Score (0-4) PrivateCo
Current ratio 1.1 1.3 1.3 13.8% 1.7 2.5
senior debt service or fixed charge 1.2 1.3 1.3 59.3% 3.2 3.5
coverage
total debt service or fixed charge 1.2 1.3 1.3 80.6% 3.7 2.5
coverage
senior debt to eBitDa 2.0 3.0 3.0 46.4% 3.0 .2
total debt to eBitDa 2.4 3.5 4.2 57.1% 3.2 .6
Debt to net worth 1.9 2.4 3.3 20.7% 2.5 1.5
revenue growth rate 0.8% 2.1% 4.5% 10.3% 1.8 7%
TABLE 16: CoMParison of surveyeD anD PrivateCo Private eQuity CreDit Boxes
Private Equity
Pepperdine Survey
1st Quartile Median 3rd Quartile Very Import. Score PrivateCo
(0-4)
revenue growth rate (minimum) 5% 5% 10% 7%
revenue growth rate (expected) 9% 10% 15% 7%
eBitDa growth rate (min) 7% 10% 10% 12%
eBitDa growth rate (exp) 10% 15% 19% 12%
Customer concentrations 40.3% 3.2 A
Market leadership 18.6% 2.7 B
historical operating performance 29.7% 3.1 C
industry sector 29.9% 2.9 D
future prospects of company 74.6% 3.7 E
Management team 67.5% 3.6 F
The Value Examiner May/June 2011 17

12. A P R O F E S S I O N A L D E V E L O P M E N T J O U R N A L f o r t h e C O N S U LT I N G D I S C I P L I N E S
ing net working capital). We simplify the ditional adjustments are necessary when investors to report on expected pre-tax
example by ignoring the impact of taxes valuing a control level of interest. cash on cash returns for new investments.
and assume that MMM qualifies for the Because we collected pre-tax returns,
maximum amounts of “cheap capital” Minority Interests discount rates from the survey should be
at the median costs. So MMM would The evidence on minority interests applied to pre-tax net cash flows.
qualify for 2.5x EBITDA in senior lend- continues to evolve. For middle market
ing, which is $5 million EBITDA x 2.5 companies, private equity groups will Diversification
= $12.5 million in bank loans. They also purchase minority interests and for doing Investors in the private capital mar-
qualify for up to 3.5x in total debt when so, most do not demand a premium in ex- kets (i.e., private equity groups, mez-
adding mezzanine financing. Since they pected rate of return as a result. Perhaps zanine funds, venture capital, etc.) gen-
already qualify for 2.5x in senior lending, one of the contributing reasons is the com- erally leverage some special industry
this leaves an additional 1x, or $5 mil- prehensive set of contracts put together to knowledge or contacts, concentrate in
lion, for mezzanine. Finally, in order to protect the fund when making an invest- certain geographic areas, or focus on
complete the capital structure at a value ment. These contracts typically include certain sizes of companies. Any one
of 7x EBITDA, the private equity group employee agreements, shareholder agree- particular fund generally contains be-
would contribute an additional 3.5x or ments, and buy/sell agreements. These tween eight and 25 different invest-
$17.5 million in financing. agreements are necessary to entice a pri- ments once fully invested, and those
Now that we have built the capital vate equity firm to purchase a minority investments have expected holding pe-
structure, we can calculate the private interest in a privately held company. riods of between three and seven years.
cost of capital as performed in Exhibit A While the Winter/Spring 2010 Pep- As a result, any particular fund is largely
(page 19). For this example, assume that perdine Private Capital Markets Project undiversified when compared to profes-
MMM qualifies for the median CAP, thus Survey (Report II) indicated that, for the sionally managed portfolios of assets in
SCAP will not be incorporated into the 70 percent of private equity firms inter- the public markets. Furthermore, there
PCOC calculation. ested in making minority investments, is a general inability to rebalance port-
The private cost of capital in this ex- a median discount of 20 percent was ap- folios by entering/exiting investments
ample is 19.75 percent. propriate, more recent data suggests most quickly. The implication is that a gen-
are making minority investments with no eral lack of diversification discount, to
SPECIAL TOPICS expected return premiums. This informa- the extent one exists, is largely priced in
There are a number of clarifications tion puts into question whether a minor- the return expectations of institutional
with regard to the application of the pri- ity interest discount should be applied for capital providers.
vate cost of capital model. The guidance middle market companies that would be
we provide is rooted in the decision- eligible for private equity investment in DLOMs
making processes actually employed by today’s economic environment. Discounts for lack of marketability
those who deploy capital in the private (inclusive of DLOLs) are assessed and
capital markets. Based upon our knowl- Cash Flow Stream: Assets or Equity? calculated relative to the specific data
edge of the activity and behavior in the The private cost of capital (PCOC) used in the valuation process. Because
private capital markets at this time we rate is to be applied to the net pre-tax cash PCOC relies on expected returns de-
offer commentary as guidance on the flows produced by the firm (free cash flows rived from new investments in privately
following 10 items. from assets). In the case of using private held companies, DLOMs are largely un-
cost of equity (PCOE) as the discount rate, necessary at the company level but may
Adjustments for Control the relevant cash flows to be discounted be relevant at the specific interest level.
The majority of investment data col- would be free cash flows to equity.
lected for private equity group capital Circularity of Value and Cost of Capital
deployments reflect control investments. Tax Value depends on cost of capital,
Since the return expectations are already The Pepperdine Private Capital Mar- and cost of capital depends on capi-
reflective of control transactions, no ad- kets Project survey asked institutional tal structure. In the private markets,
18 May/June 2011 The Value Examiner

13. A P R O F E S S I O N A L D E V E L O P M E N T J O U R N A L f o r t h e C O N S U LT I N G D I S C I P L I N E S
TABLE 17: DeterMination of PrivateCo’s CaP By CaPital tyPe
Capital Type Market Value CAP 1st Quartile 3rd Quartile SCAP PCOD PCOE
Cash flow loan $500,000 6.5% 5.4% 7.1% .6% 7.1%
Private equity $13.7M 30.0% 25% 30% 0% 30%
TABLE 18: PrivateCo Private Cost of CaPital CalCulation
Capital Type Market Value % of Total Adjusted CAP Tax Effect Weight x CAP
PCoD $500,000 4 7.1% 0% 0.25
PCoe $13,700,000 96 30.0% 0% 28.95
Pre-tax Private cost of capital 29.2%
ExHIBIT A: MiDDle MarKet ManufaCturing, inC. (Market value Balance sheet)
Cost of Capital
assets $M liabilities and equity $M invest. size (CaP)
net working capital 0.0
long-lived assets 35.0 senior Debt 12.5 2.5x 5.5%
subordinated Debt (Mezz) 5.0 1.0x 19.5%
equity 17.5 3.5x 30.0%
Total Assets $35.0 total liabilities & equity $35.0 7.0x
eBitDa $5
Multiple 7x
Market value $35M
PCoC = (CaP * % market value) + …PCoC = [5.5% * (2.5/7)] + [19.5% * (1.0/7.0)] + [30.0% * (3.5 / 7.0)]
Pre-tax PCoC = 19.75%
deal values are obtained by applying Optimal Capital Structure It is likely that many companies
a multiple (most often of EBITDA) to In the private capital markets, each will not qualify for capital types less
a recast EBITDA stream. Then the at- capital structure is built one company at expensive than factoring. In these
tention turns to securing financing to a time. The strategy in arranging the op- cases, the appropriate volume level of
support the deal. Since that process is timal capital structure is to start with the factoring should be used. For exam-
how capital structures are arranged, cheapest sources of financing and then to ple, companies that factor $250,000
we recommend using deal multiples to move to the next most expensive source receivables per month have a median
first estimate the company value. This once the maximum amount of capital is CAP of 58.5 percent. We believe that
exercise will initially arrange the capi- obtained or after determining the com- most companies of size qualify for
tal structure so that the PCOC can be pany wouldn’t qualify for that particular factoring, and that the high cost of
calculated. Further refinement may be capital source. Repeat this process until factoring reflects its role as the capital
necessary afterwards, however. all of the capital structure is arranged. provider of last resort.
The Value Examiner May/June 2011 19

14. A P R O F E S S I O N A L D E V E L O P M E N T J O U R N A L f o r t h e C O N S U LT I N G D I S C I P L I N E S
Friends and Family Investments
For companies that are able to tap TABLE 19: ManufaCturing CoMPany
friends and family as a financing source, Cost of equity Capital Comparison: Buildup vs. PCoC by size (spring 2010)
it shouldn’t be assumed that the terms $1M $25M $250M
are at arm’s length and in accordance
risk-free (survey) 4.0% 4.0% 4.0%
to “market” pricing of risk. Frequently
equity risk Premium (survey) 6.2% 6.2% 6.2%
friends-and-family financing is extend-
ed at below market rates because of a industry adjustment (survey) 2.0% 2.0% 2.0%
special relationship that exists. In these size Premium (survey) 6.8% 5.8% 4.0%
instances, it is not appropriate to use Company specific (survey) 5.0% 3.8% 2.3%
the terms of a friends-and-family loan
Buildup equity rate (after-tax) 24.0% 21.8% 18.5%
or investment.
Buildup equity rate (pre-tax @ 30%) 34.3% 31.1% 26.4%
Small Companies
Small businesses (those that don’t DloM (survey) 20.7% 16.6% 14.0%
qualify under any of the credit boxes in
Buildup equity rate (Pre-tax, DloM-adjusted) 41.9% 36.4% 29.9%
the survey) rely on a variety of financing
PCoC (Pre-tax as reported) 30.0% 30.0% 25.0%
sources that are not priced by institu-
tional capital providers. Small business Difference 11.9% 6.4% 4.9%
owners commonly rely on personal in-
vestments (savings, investment portfolio,
home equity), friends and family, credit and tax treatment, we observe lower net owners, lenders, investors, estate plan-
cards, and loans with personal guaran- discount rates using PCOC. One poten- ners, and so forth—rely on valuation
tees. As a result, the Pepperdine cost tial explanation for the difference is that methods that are specifically useful to
of capital survey does not have market- PCOC rates may reflect costs of capital for making decisions in their markets.
driven empirical data at this time to sup- higher quality privately held companies on Why do parties in the private capital
port discount rates for this segment of the average.11 markets not employ public information
economy. Any capital extended based on In any event, using PCOC as a start- in their decision-making process? Be-
a requirement that personal income or ing point will result in significantly few- cause these parties have real money in
assets be pledged will not reflect a pure er adjustments and is more aligned with the markets; valuation is not notional to
business risk-adjusted cost of capital. the actual markets in which privately them. Making proper financing and in-
held companies raise capital. vestment decisions requires using theo-
COMPARISON TO CURRENT ries and methods that are appropriate to
PRACTICE RAMIFICATIONS OF USING PCOC the subject’s market, such as choosing the
One may wonder how PCOC compares The temptation to use readily avail- correct value world and resulting process
to equity discount rates currently used in able public information to value private when making a valuation decision.
practice. In Table 19, we compared PCOE companies is strong. Note that within the Using a discount rate that is derived
estimates from PCOC to those median in- private capital markets, mainly academics from empirically derived, private data
puts obtained from the business appraiser and business appraisers use the guideline could alter professional, legalistic, com-
survey in the Pepperdine study.10 Once public company method. Other parties pliance business appraisal in four ways.
adjusting for differences in DLOM usage in the private capital markets—business First, adjustments such as lack of mar-
ketability discounts and control premi-
10 Appraiser results are reported in Pepperdine
Private Capital Markets Project Summer 2010 11 We assumed rates reflected controlling
ums may not be needed. These adjust-
report with exception of the DLOM for controlling interests and also applied DLOMs based upon ments were originally created based on
interests, which was not surveyed until Spring 2011. survey results for controlling interests. Final the faulty premise that public return
Some of the reported differences, particularly in estimates ultimately depend on the facts and
the $1M category, may be attributed to appraisers circumstances of the information pertaining to the expectations could be manipulated to
estimating on revenues versus EBITDA. subject interest.
20 May/June 2011 The Value Examiner

15. A P R O F E S S I O N A L D E V E L O P M E N T J O U R N A L f o r t h e C O N S U LT I N G D I S C I P L I N E S
derive private values. Once risk is de- rently, an industry of business apprais- needs. This direct estimation process
fined using private return expectations, ers inhabits mainly the notional value significantly reduces the need for many
these public-to-private adjustments are worlds. Business owners need more “public to private” adjustments such as
largely unnecessary. help in competing in a global economy. DLOMs and control premiums, and
Second, PCOC provides a risk def- The value gap—the difference between more importantly, provides appraisers
inition that can be applied across val- what owners want/need the market a framework for helping private com-
ue worlds (standards of value). Each value of their businesses to be and the pany managers deal with value creation
world also has an authority, which is value the market assigns—has never measurement and management. VE
the agent or agents that govern the been larger. Tools like the PCOC model
world. The authority decides whether will help the appraisal industry become John K. Paglia, Ph.D.,
the intentions of the involved party are more value-added. CFA, CPA, is the Den-
acceptable for use in that world, and ney Academic Chair
prescribes the methods used in that CONCLUSION and associate professor
world. More specifically, authority The private capital markets offer of finance at Pepperdine
refers to agents or agencies with pri- market-based solutions to arranging University in Malibu,
mary responsibility to develop, adopt, capital structures and determining pri- CA. He is also director
promulgate, and administer stan- vately held company values. These mar- of the Pepperdine Pri-
dards of practice within that world. kets evaluate risk, and price that risk, vate Capital Markets Project. E-mail:
Authority decides which purposes in conjunction with granting credit or john.paglia@pepperdine.edu.
are acceptable in its world, sanctions deploying investment capital. Despite
its decisions, develops methodology, the proliferation of the private capital Robert T. Slee, CBA,
and provides a coherent set of rules market segments over the past couple CM&AA, is managing
for participants to follow. Author- of decades, there has been relatively director at Robertson &
ity derives its influence or legitimacy little attention paid to the return expec- Foley, a middle-market
mainly from government action, com- tations of providers of capital as a basis investment banking firm
pelling logic, and/or the utility of its for discount rates. in Charlotte, NC. He is the
standards. Authorities from the vari- With four survey cycles completed, founder of MidasNation
ous value worlds will finally have an the Pepperdine Private Capital Markets (www.midasnation.com),
empirically derived method of defin- Project collects data on the activity and an online community for private business
ing risk. Hopefully these authorities behavior of the private capital market owners. E-mail: rob@robertsonfoley.com.
will prescribe use of PCOC in their segments. Data collected include credit
respective worlds. box statistics and return expectations
Third, business owners will finally based upon actual investment checks
be able to determine their companies’ written. These empirical data points,
cost of capital. This knowledge will help including return expectations, can now
them learn whether they are creating be used to derive privately held com-
economic value; that is, generating re- pany costs of capital. One such model
turns on invested capital greater than that employs the Pepperdine data is the
this cost. This should promote eco- private cost of capital model.
nomic value creation as a practical and The PCOC model is a market-based,
useful tool. Plus it opens an avenue for empirically driven solution for estimat-
business valuators to consult with busi- ing discount rates for privately held
ness owners to help them make better companies. PCOC makes the discount
investment and financing decisions. rate estimation process relevant by ex-
Finally, the PCOC model will make amining the actual markets where pri-
business appraisal more relevant. Cur- vately held companies fund their capital
The Value Examiner May/June 2011 21