Lessons Learned from Challenging Times
By Robert S. Hill, Principal
J. H. Chapman Group, Investment Bankers
We are a Merger & Acquisition advisory firm. Consequently we
spend a lot of time talking to clients and prospective clients about
current market conditions for buying and selling companies. Because
a portion of our practice involves franchisees and franchisers,
our client conversations often contain reminders that a shift in
current market conditions frequently has an exaggerated impact on
franchise value and franchise transaction structure.
Nothing could be more relevant as we enter another year of very
tight, and some would say disappointing, times for M & A activity
in the middle market, where most franchise activity lies. Mid market
multiples that were 6 – 7 a few years ago are now 4 –
5. The number of completed transactions is also down significantly
from a few years ago.
A good example can be found in the Food Institute’s tracking
of M & A activity including the restaurant sector – where
a lot of franchising activity exists. According to FI, the restaurant
and foodservice sector normally produces more than 100 transactions
annually (140 in 1998). The sector had only 48 in 2002 and 61 in
2001, and last year’s total was only 34% of the 1998 high
point. The exaggerated impact for franchising is evident when comparing
the restaurant /foodservice sector’s 34% to the entire food
industry’s 51% for the same time period.
Because we see encouraging signs on the horizon pointing to a stronger
market, we believe it is a good time to think about lessons learned
and to consider desirable preparations as owners of franchise businesses
contemplate jumping into the market either as a Buyer or Seller.
Lesson Learned: Owners of cash-flow strong
but asset-weak companies may have a tough time achieving their value
For owners of a franchise business, the most important development
in recent years affecting their ability to close a purchase or sale
transaction is the disparity in importance that cash flow plays
in determining value and purchase price vs determining debt capacity.
As with much of the non-public middle market, cash flow expressed
as EBITDA is the single overwhelming factor determining value. Buyers,
sellers and investment bankers think in terms of multiples of EBITDA,
usually trailing 12 month EBITDA, as the primary method of expressing
purchase price and comparing relative transaction pricing or “trading
range” within industry groups.
However, many proposed transactions with Purchase Price agreements
in hand have fallen apart because acquisition financing to support
the agreed purchase price cannot be achieved. Why? Because most
lenders active in the franchising sector today do not assess value,
and therefore loan exposure, the same way Buyers and Sellers do.
While they may express the result of their analysis as a multiple
of EBITDA, they frequently do not arrive at their proposed loan
amount that way. For example, while they may complete a detailed
cash flow analysis, lenders will often impose a limiting factor
tied to their assessment of collateral value. The result has been
a significant reduction in advance rates.
Our firm’s annual census of restaurant M & A activity
shows a marked decline in prevailing debt multiples from approximately
5.5x in the late 90’s to approximately 3.8x in 2002. While
there is good news according to a recent U. S. Bancorp Piper Jaffray
survey which concluded that debt multiples were inching up, perhaps
to the low 4’s, these multiples are far below the value-creating
5’s and 6’s seen a few years ago.
In addition, the last few years have seen a significant rollback
in the number of cash flow lenders participating in the middle market
and particularly in the franchise sector. The enormous loan defaults
in recent years have taught us that asset or collateral value is
king when it comes to loan values, and nowhere is this lesson more
evident than in the franchise sector. Lower advance rates have imposed
a cap on purchase price multiples and have stifled a significant
amount of transaction volume.
For Buyers and Sellers, the good news is that cash flow lending
is starting to come back with the emergence of some very creative
and aggressive lenders, but the market is a long way from the go-go
years of the mid 90’s where cash flow was king and asset collateral
was a second thought.
Lesson Learned: Deal structure, deal structure,
It used to be that Buyers could obtain senior debt, add some equity
and close an acquisition paying cash to the seller who blissfully
retired to Arizona to live off the fruits of his good fortune. No
Complex transaction structures have become commonplace in today’s
M & A market. While transaction structure has always had a role
in mid market M & A circles, never more than in the last couple
of years. The reasons are many, but among the more important are
- The significant shift in lender methodology and
the substantial reduction in advance rates as discussed above.
If a transaction is fairly priced at 5.5 x EBITDA but the senior
lender will advance only 3.5 x, a significant value gap will need
to be closed. While “more equity” will work, this
is typically not the option of choice for most buyers.
- Increased competition for acquisitions between
strategic buyers and financial buyers combined with the differing
evaluation methods applied by both buyer types to assess acquisition
opportunities. For example, financial franchise buyers may be
very sensitive to the amount of pure equity going into a transaction
and often will seek out a variety of “near equity”
capital sources to minimize their “hard” equity contribution.
Strategic franchise buyers may be somewhat less equity sensitive,
but they will often be very cautious about post-closing issues
including protection from seller induced competition, hidden liabilities
and required capital expenditures.
- In the franchising sector, the presence of a
third constituency at the closing table (the Franchiser) who may
use the change in ownership as an opportunity to achieve other
capital consuming objectives like image upgrades or marketing
The end result is that Buyers need to be much more
creative to achieve their desired return on equity and close a transaction
while Sellers need to be prepared for a variety of post-closing
consideration, continuing seller participation (usually subordinated)
and residual liability indemnification.
Lesson Learned: More of a good thing is not necessarily
a good thing.
The decade of the 90’s saw unprecedented growth and consolidation
within the franchise sector. Large franchisees grew. Small franchisees
sold out. Some of this activity was actively encouraged by franchisers,
some was the natural result of well intentioned synergy and consolidation
analysis pointing to better profit margins, some occurred as franchising
attracted growth-minded entrepreneurs very adept at raising capital.
But as boom times turned to bust for many buyers and lenders, one
wonders what happened to the simple truth of franchising.
For many franchise concepts, the basic business proposition is
low tech, on the street, in the neighborhood where local market
knowledge and local presence counts.
Our view of the horizon shows brighter times ahead, but we think
one’s franchise growth strategy should keep in mind that simple
- If the expansion choice were a) same concept
1000 miles away or b) second concept at home, the latter often
offers less risk, more efficient utilization of management resources
and therefore better long term payback.
- If the expansion choice were a) 30 sites leased
or b) 15 sites on fee property, fee properties are often a better
choice because they provide collateral value, longer term debt
capacity and a diversified cash flow stream (inter company rent)
less prone to the ups and downs of franchiser marketing programs.
And fee properties pay a dividend for a franchisee’s local
market knowledge as well as provide for the owner a second exit
- If the expansion choice were a) keep my current
level but reliable performer and buy a small position in an exciting
upstart or b) sell my level performer and buy a much larger position
in the same exciting upstart, choice (b) may offer more long term
potential because many of a franchisee’s skills and much
of his market knowledge is transferable to other franchise concepts.
Many business owners have missed good opportunities because they
couldn’t bring themselves to part with a company at current
values when historical values had been higher.
In conclusion, we believe exciting times are on the horizon, but
those exciting times will be characterized by vexing challenges
and an increasing need to be flexible and creative. The lessons
of the last few years will prove to be valuable to those who take
the time to learn from them.