Franchise Times — September 2011
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Mixed Bag
Jonathan Maze

Finance & Real Estate

Does Wall Street affect Main Street financing?

Lending is improving, but not for everybody, and now renewed worries of a double dip recession could make matters worse.

Beata Krakus had a busy spring.

The Chicago-based attorney with Greensfelder, Hemker & Gale investigates franchises for the private equity groups that buy them, and a sudden flurry of deals earlier this year led to some long hours.

Then it all stopped. “We had four deals simultaneously this spring,” she said. “Now, we’re not working on any deal like that.” That’s not entirely abnormal—deals come and go, and summer is frequently a slow period. But then the stock market tanked in early August, which left her questioning whether this was a larger trend. “I find it hard to predict what’s going to happen,” she said. “Sometimes, what happens on Wall Street doesn’t translate.”

Franchise owners and executives are probably hoping that it doesn’t. Finance markets have been on something of a rebound this year, making life easier for buyers and developers of franchises. But new signs of economic weakness reignited concerns about A double-dip recession, and by extension the market for financing deals.

“We were getting to a point with terms and deals and covenants that people started to say, ‘Oh my goodness, we’re approaching levels where we were four years ago,’” said Bob Bielinski, who heads the restaurant industry practice for CIT. Yet recently, he said, the market took “a bit of a step back. They’re taking a time out, taking a breather. They’re concerned about the economic environment.”

Still, few people we spoke with indicated that the fear in the markets, and the consumer pullback this summer, are spreading to the franchise finance sector—at least for now. “We don’t see it, real time, affecting our ability to do deals,” said Trey Brown, senior managing director and commercial leader for GE Capital, Franchise Finance.

Further decline in economic weakness could change that. “We don’t know, short or long term, how this will play out,” Brown added.

In the meantime, the general view is that the lending market is improving. The Federal Reserve’s Senior Loan Officer Opinion Survey in spring, for instance, found that lenders are easing standards. But there are some caveats: the market isn’t improving for everybody, and loans are taking longer to process. “Senior lending is still very tight and conservative,” said David Hill, managing director at California based Innovation Capital.

Banks are returning to the basics of lending, and are shying away from risk. Better borrowers from better concepts are getting loans. And banks are taking more time investigating a loan request, so processing takes more time. “Projects are still getting done,” said Randy Jones, partner at Funding Solutions. “Banks are doing more due diligence. If the project makes sense, I think the projects are getting done.”

But the uneven improvement means lots of projects won’t get done. Demand for loans remains strong. Brown, for one, expects his company to beat its plan for the year. “Demand is twice what it was a year ago,” he said. Still, financing for that demand is expected to fall short. The International Franchise Association and Frandata estimated in March that loans to franchises would fall $2 billion short of demand this year, helping solidify the association’s drive to cajole the government into improving small business lending.

In simple terms, better performing franchises and operators will get lending, and those that aren’t performing as well—or aren’t perceived to be performing as well—will struggle to get necessary capital. “There’s plenty of loan supply for good concepts,” said Lex Lane, vice president and business development officer for United Capital Business Lending. “If you’re doing well in this environment, theoretically you should do better when the economy is strong.

“Everything depends on credit. And when chains are struggling, they don’t grow as fast.”

A lot of the focus recently has been on the quality of the franchisor. Lenders are more likely now to look at the system’s overall performance in deciding a loan. They also tend to Avoid new, unproven concepts. So franchisors have been taking increasingly aggressive steps to assist their franchisees. Franchisors have to consider guaranteeing franchisee loans to assure new development financing. Short that, they have to be aggressive in providing information.

Credit availability is a bigger problem for new development, especially with concerns that some industries—especially restaurants— are saturated. “It’s amazing how many concepts there are,” Lane said. “As a lender, you really have your work cut out for you. You’re not doing super long-term loans. And you have to guess who is going to win, and who is going to lose.”

The difference in financing availability from one concept to another is also common in the acquisition market. Buyers of struggling legacy Chains such as Arby’s or KFC are more likely to find a difficult time on the credit markets. Buyers are almost always existing operators within those concepts with cash, good relationships and preferably little debt.

For the most part, however, acquisition financing is easier to obtain because it is less risky. “I’d rather do acquisitions all day long,” Lane said. “Franchises would rather see new development.”

Lenders are also loaning at higher amounts than they did a year or two ago. A July survey on the lending climate by Phoenix Management Services found that 40 percent of lenders indicated their financial institution would consider a loan request in which the debt is 3- to 3.5-times as much as its earnings before interest taxes depreciation and amortization, or EBITDA. Lane said his bank generally would approve loans at 2.75- to 3.5-times EBITDA. Rob Hunziker, managing member at Advanced Restaurant Sales, said lenders generally loan 3- to- 3.5 times earnings. And interest rates remain low—7 percent, Hunziker said, but sometimes go down into the 6-percent range. “Life is not bad, particularly if you’ve got cash,” he said.

One challenge for sellers, however, is what is known as seller paper—which is basically a mezzanine loan from the seller. “A lot of buyers like to see the seller take back a little paper,” Hunziker said. “It gives the buyer confidence that the deal is worth what he’s paying.”

For now, the overall franchise-lending environment remains on an upward trajectory, albeit a slow one, but that could change if the economy turns south. Bielinski, who generally oversees larger deals, said that persistent weakness this month after Labor Day—when a flurry of deals is expected—could hamper credit.

“I think the debt markets are very much living with the uncertainty of the economy,” he said. “They’re living week-to-week, number-tonumber. The condition of the debt market in September will depend on what the data looks like.”

Want Financing? Have Good Franchisee Relations

Lenders consider plenty of things when looking at whether to make a loan to a franchisee—the system’s financials, the performance of operators, market competition and the prospective franchisee’s strengths. But here is one piece of the lending puzzle that doesn’t get much attention, but probably should: the franchisorfranchisee relationship.

Bankers consider the health of that relationship in the lending process. So systems with a more tense franchisorfranchisee environment will have more trouble getting loans.

And the relationship works both ways, so bankers are looking for franchisors that support operators during the recession. They’re also looking for systems where franchisees support the franchisor’s brand efforts.

“Commitments have to be made on both ends to preserve the health of the system,” said Trey Brown, senior managing director and commercial leader for GE Capital, Franchise Finance. Banks like to see franchisors reimburse parts of reimaging programs, for instance, because it shows that the brand is committed to the effort.

Perhaps surprisingly, those relationships have been fine during the recession. For the most part, franchisors and franchisees are more likely to work together now, contrary to expectations heading into the downturn that fights and lawsuits would be more common. “We’ve been pleasantly surprised,” Brown said. “More have, than have not, shown the ability to close ranks and reconnect.”