Bank Loan Volume is Down and Fear is Rising

1. The Current Senior Debt Lending Environment and Implications for Middle Market Government ContractorsNovember 20, 2008Eric A. PietrasSenior Vice President

2. Bank Loan Volume is Down and Fear is Rising • Bank lending volume is down since the meltdown of September 17, 2008 when the government seized AIG; fear is rising. • Fewer syndicated deals have been launched since the meltdown, and a few smaller deals came to market to an uncertain reception; total syndicated loan volume was down 76% for the first three quarters of 2008 versus the same period in 2007. • The Chicago Board Options Exchange (CBOE) Volatility Index (VIX or the Fear Index) reached an all time high on October 10. • VIX measures the degree to which investors think stocks will swing violently in the next 30 days. It is calculated in real time throughout the trading day, fluctuating minute to minute. • The higher the VIX, the bigger the expected swings. • It also spiked in 1998 when the Long-Term Capital Management hedge fund collapsed, and after the 9/11 terrorist attacks.

3. LIBOR Volatility • The movement in LIBOR represents yet another indicator of market fear (in addition to the plummeting of the Dow, the surging of the Commercial Paper markets, etc.) • Upheaval spreads to the interbank market, driving up both LIBOR (and term swap rates). • Intensified after the failure of Lehman Brothers (September 15), causing the LIBOR to double. • In October, LIBOR surged as banks preserved their capital amid uncertainty surrounding interbank counterparty risk and funding availability; on October 13, for the first time in weeks, LIBOR declined modestly. • On October 8, the central banks of the US, England, Canada, China, Switzerland, Sweden and ECB lowered interest rates. The Fed cut the Fed Funds rate by 50 bps. to 1.5%. • Further Fed rate cuts are possible given lower inflationary expectations associated with global recession. • LIBOR is historically about 250-275 bps. under Prime. However, on 10/10/08, 30-day LIBOR spiked from 2.48% on 9/15/08 to 4.58% at 10/15/08, while Prime was lowered twice during the same period from a high of 5% to its current 4%, skewing this historical relationship by virtually converging. • (As of 11/18/08, 30-day LIBOR has dropped to 1.45% or 2.55% under Prime, more reflective of the historical relationship between the indices.)

4. History of LIBOR Over the Past Year

5. Ten Year Relationship of LIBOR to Prime

6. Financial Upheaval Has Reduced the Number of Players and Increased the Need for Costly Capital Raises • Mortgage market meltdown, bank credit write-downs, and resulting turmoil in the financial services sector continue to create unprecedented and spreading global liquidity challenges. • Recent events include: • Fannie Mae and Freddie Mac put into U.S. government conservatorship. • Lehman Bros. filed for Chapter 11 bankruptcy. • BofA agrees to buy Merrill Lynch in an all-stock $50B deal; JP Morgan and Wells acquire WaMu and Wachovia, respectively. • The U.S. government extended an $85B (now $120B) loan to AIG and took a 79.9% ownership in the company. • Morgan Stanley and Goldman Sachs become regulated bank holding companies, ending the investment banking era. • Fed agrees to extend credit directly to corporations through the direct purchase of commercial paper, and announces plans to use up to $250B of the $700B rescue package to inject capital directly into banks ($125B for the top 9 and $125B for smaller banks.) • The meltdown extends globally as central banks take control or provide support for indigenous banks.

7. Defaults Rose in 2008, and Expectations for 2009 are Worse • Default rates are up to 3.59% from 0.26% at the end of 2007; ratings agencies expect defaults to climb to 5.00% by year end, on the way to at least 8.0% in 2009. • Default for Government IT and Aerospace and Defense companies are virtually non-existent. • Biggest default sectors are real estate, auto, gaming, transportation and chemicals. • Companies in default are paying dearly for relief • Record number of amendments in 2008, accompanied by concurrent ratings downgrades. • Banks and investors charged an average of 164 bps. More in interest to amend borrowing agreements and avoid default, according to S&P, the highest since 1997 and almost eight times more than 2007.

8. Outlook for 2009 – Tighter Standards, Fewer Investors • Capital is constrained and Credit standards are tightening • According to a recent survey of bank credit officers, 58% of banks have tightened lending standards; many believe the percentage is much higher. • Covenants have become increasingly strict in 2008 and there has been an increase in the average number of covenants to 2.6 from 2 in 2007. • EBITDA add-backs are limited, if permitted at all • The number of investors is shrinking (Non U.S. banks, U.S. banks and thrifts, finance companies and securities firms.) • Future deals will likely have the following characteristics: • More and tighter covenants • Highly negotiated baskets • Shorter tenure • Increased scheduled amortization plus a prevalence of excess cash flow sweeps • No or limited permitted distributions • Very limited acquisition facilities

9. Implications for Middle Market Government Contractors • There are banks out there with lending appetites and open lending doors; select regional lenders have the capital, liquidity and willingness to lend. • Deals are getting done for “quality” credits. • For banks that “get it”, typically those with specialty groups serving the sector, it is understood that government contracting is generally safe and largely immune to macro-economic conditions negatively impacting other sectors. • Expect pricing adjustments “to market”, especially during requests for modifications or renewals; except for the top echelon of companies in the sector, there will be fewer deals with LIBOR spreads starting with a “1”; expect at least a 50 basis point LIBOR spread increase for a comparable level of credit risk. • Forget highly leveraged cash flow deals for the time being, as institutional investors like GE Capital, as well as many traditional commercial banks, have pulled out of the market for the time being. • Expect generally lower leverage tolerance, not typically exceeding 2.75x-3.00x for senior and 3.00x-3.25x for total debt leverage multiples.

10. Implications for Middle Market Government Contractors – Underwriting Points • What are some the things that define an attractive and “quality” GC lending opportunity: • Strong, proven management team and financial back office • Management view that their bank, along with their accounting firm, attorneys, investment banker, consultant, etc. are consultative partners, not providers of a commodity; high level and frequency of communication (good or bad) • Niche capabilities set with high barriers to entry • High degree of contract backlog diversity and predictability • Predominance of full and open contracts (or at least a well articulated path to get there for smaller companies playing in the set-aside area) • Demonstrated willingness to retain capital • Demonstrated business development infrastructure and win success rates • Especially for more leveraged acquisition opportunities, a willingness on the part of management to put “skin in the game” • General avoidance of non-core business investment opportunities, especially those which are commercial in nature

11. General Relationship of Senior Debt to Other Sources of Capital in a GC Acquisition Scenario • Our general approach, given the satisfaction of some of the favorable credit attributes just outlined, is to first “load up” an asset-based revolver, leaving at least a full payroll cycle in excess availability for ongoing working capital needs. • Next, we look to structure senior term debt (“airball financing”) as necessary up to an acceptable senior leverage multiple by underwriting the company’s contract backlog (diversity, predictability, waterfall, etc.) to determine the company’s ability to comfortably service, through EBITDA, a term loan outside of the “borrowing base” such that collateral coverage (from a combination of principal amortization, excess cash flow recapture, borrowing base reserve, etc.) is achieved within a reasonable amount of time, generally no more than 2-3 years. • Additional sources of funds required to make the deal “work” (given our satisfaction of valuation and purchase price reasonableness) will then be allocated first to mezzanine or subordinated seller financing (up to our total leverage threshold for that particular transaction), and then to equity sources as available.

12. THANK YOU!