Franchise Finance Observations

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We recently attended the 2010 Restaurant Finance and Development Conference, and  some relevant notes follow: 


  • More money is theoretically available but the lending standards are much practically not much has changed. 
  • Franchisors still have a valuation and debt capacity premium and can borrow more, at less, than even multi-unit franchisees. 
  • With maturing franchisee systems, the "renewal risk" of franchisor systems is becoming more visible. 
  • Associations should document and prepare. 
  • Some "lower tier" operators (recent example Dairy Queen) will have trouble refranchising and finding lenders for franchisees. 
  • Franchisors were promised a detailed "proctological like review'' of their franchise systems. 
  • Big Bank loan underwriting standards are tough and consider everything. 

Big Picture

A lot more franchisors attended. The theme of the conference was---it depends! (financing, brand, valuations, etc). 

Talk was that money was available to qualified borrowers (albeit very high standards), but many audience members didn't buy that. 

Macro economic conditions will be difficult in the US for some time. 

Loan underwriting standards VERY specific and detailed. 

Today's underwriting standards would have prevented many prior years' executed M&A actions from having much in future CAPEX, due to leverage. 

Restaurant Finance Availability, Rates, Terms and who Qualifies:

Much more liquidity/$ now present, but now looking for much greater equity (cash) infusion from operators. 

Max for senior debt, about 3 times EBITDA at LIBOR plus 350 to 500 bpts; 1.5 X for non-secured & mezzanine debt at12 to 18%. 

More capital available but fewer good prospects. Hard to find $ if most/all of system tied up as collateral to another lender. 

We examine each brand separately. Mixed opinion of the classical company versus franchisee mix argument. 

Some lenders not hung up on the same store sales increase test but look to see operator is operating as best possible. 

Lenders like restaurants that are voracious consumers of CAPEX. 

Look for franchisors to undergo extensive due diligence. In evaluating packages, lenders want dependable cash flow and definition of leverage to be clear. Specific concern about franchisor franchisee renewal rates noted (with many franchisees entering retirement zone).

Lenders want fixed cost coverage ratio to be 1.4 times zone (was 1.25). CIT has survived and GE Capital is back in the market too, but they want big transactions, over $10M EBITDA. 

Restaurant M&A Trends

Franchising Specific Notes Market conditions: lots of competition for deals now versus no demand last year. Investors view restaurants in a bond like relationship--should be low risk, it's a tangible, easily understood business (supposedly). 

Not a lot of distressed companies right now, but some coming. 90% of transactions from private equity, 10% strategic purchases. 

The numbers: One advisor is looking at franchisors at 9.5 times (X) EBITDA, casual dining at 7 X, upper end/fine dining at 7X. 

Franchisors have a premium over franchisees since they have a wider geographical area to expand. Typical leverage: 2.5 to 3.0 times EBITDA for senior debt, 1-2 times for mezzanine debt. Distressed company deals must be all equity. One saw QSR zees at 6-8 X EBITDA without real estate, a bit less for casual dining brands. 

There were questions whether the Burger King (BKC) buyout of appx. 9.2 X EBITDA set a new comparable price benchmark. Consensus not. 

It depends and it varies by brand: was often cited as the overall rule of thumb. All brands are not the same. The franchising premium (reliable cash flow and less CAPEX) remains. 

But franchisors should expect a detailed system diagnosis review of system health and prospects. 

A Purchasing co-op is a plus. 

One noted franchisor seller expectations were still too high, particularly if real estate was involved. 

Remodel economics; noted IHOP refreshes ($50 to $75K) with no sales lift, Pizza Hut $350K remodels at a 10% AUV lift, and a rescrape/redo ($600 to $700k) at a 30-35% AUV lift. 

Minimum standards PE firms want; increased equity, operational expertise and legacy financing. 

Outstanding or future CAPEX requirements (e.g., rundown restaurants) will affect the price multiple. 

Commercial Bank's Detailed Underwriting Standards: 

Little is not known or examined. Loan standards of all types exist and are tough. 

 ? EBITDA definition: maintenance CAPEX is subtracted from the traditional EBITDA definition. Typically 0- to $50K per unit/year. 

 ? Traditional Funded Debt to EBITDA metric: 2.75 X to 4.50 X ? Lease adjusted: total loans outstanding plus eight times rent expense, to EBITDA: between 5.25 to 5.50 for operators and 5.50 to 5.75 X for franchisees 

 ? Senior and Total Lease adjusted leverage: senior: 4.75 to 5.25X, total leverage 5.25 to 5.75X 

 ? Fixed Charge Coverage ratio: EBITDAR divided by Principal plus Interest: not less than 1.25 to 1.50 times for franchisees. 

 ? Cash EBITDA Standard: EBITDA -cash taxes-maintenance CAPEX divided by Interest plus principal: should be 1.15 to 1.25X 

 ? Capital Spending (CAPEX): per business plan except if lease adjusted leverage ratio is 5.25 or higher, new CAPEX likely limited. 

 ? EBITDA add backs: yes, the lender will listen if there are large non-recurring or extraordinary EBITDA effects. 

Generally, focus is on business cash flow before owners compensation. 

Private Equity and Restaurants: 

Market Conditions; debt is coming back in vogue but still scarce for small companies.  

Targets: multimarket successful operation, strong brands, $10M and up EBITDA. CFOs Panel 

The most interesting exchange here was the Chipotle perspective, that they didn't need to do franchising as they had the capital, the people, the expansion plan and the unit economics already in place, while Five Guys noted the US was "sold out" but that they were looking to do 30 company stores and 200 franchisee units next year. Interestingly, Five Guys likes small franchisees, as they feel multi-concept operators won't follow the Five Guys way. 

Heartland/BKC noted how reliant they were on the BKC brand and that they were looking to Canadian but no US expansion. 

Scouring the P&L for savings: Budgeting has become more sophisticated, with both internal (stretch) and external forecasts being developed. 

Cost savings targets; service provided contract costs, too much outsourcing is not cost effective (internal training), challenging tax assessments, implementing new labor guides via POS technology. 

Marketing: direct mail, elimination of low volume menu offerings, sees social networking as high marketing ROI. 

Financial Returns: 30% cash on cash or 3.3 year ROI still best in class standard, but franchisees were in the high teens. 5 year return or 20% cash on cash seen as realistic.

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