“New Types of Financing ”		«BACK
	by Dennis L. Monroe
	from August 2006 Franchise Times
	download .pdf

For many years franchise financing has been effectively illustrated as a continuum.  On the far right of the continuum is the most conservative type of financing - senior debt.  Senior debt is dominated by banks and large commercial finance companies (e.g., GE, Bank of America, Wells Fargo and other groups).  These groups want reasonable returns through interest payments.  On the far left side of the continuum are equity investors who may initially consist of friends and family and move to private equity and finally to the public market.  These equity investors take the highest risk and expect the greatest return.  There have always been players in the middle of the financing continuum.  These players are mezzanine lenders, hedge funds and sometimes public debt companies.  The mix of the use of debt, equity and mezzanine financing has often been determined by the company’s needs, present performance and future projections.

Over the years we have developed many financing tests (such as debt to equity, fixed charge coverage ratios, liquidity ratios, and tangible net worth to debt); all of these tests are involved in the determination of the relationship between debt and equity. 

Recently the line between equity and debt has become blurred.  The idea of leverage at three or four times cash flow (or what we call the debt to EBIDTA ratio) has now been minimized.  New players have stepped into the franchise finance space.  These players defy classification.  Some are hedge funds, but many are also just creative private equity groups.  These groups are not as interested in the traditional ratios of debt to equity.  They are more interested in the question, “Can the borrower (i.e., the target, whether it is a franchisor or franchisee) effectively repay the funds that have been provided?”  This has created a new dimension in the franchise finance space.

We see much higher leverages today than what we seen in the past.  Senior lenders are rather traditional in their approach to leverage while these new groups think in terms of the borrower’s ability to repay or refinance over the long term.  These funds (usually hedge funds) take the money they have available from investors and borrowers and then loan the money to franchise businesses.  The franchise businesses may look at these funds as equity and debt, but in most cases the funds are debt with a fairly high interest rate.  The rate is sometimes 400 to 600 basis points over what would normally be paid to a senior lender. 

In most cases, these new types of investor lenders will also provide a certain degree of equity; not to excess, but something in the neighborhood of 10% to 30% equity and 70% to 90% debt. 

The overall cost of funds to the franchise business is equal to or lower than what would be found in a traditional approach of straight equity and then a significant layer of senior debt.  If there is a shortage of funding, one would usually look at mezzanine debt, but instead we have a large facility of money with a small equity component and higher price debt, thus lowering the overall cost of funds. 

What do these new types of funds mean to the franchise business owner? 

Many of the recent transactions have this type of component.  One example is the NPC (National Pizza Company) transaction which has a fairly high level of debt and very high purchase price.  The Dunkin Brand acquisition will, in the end, have a very high component of debt.  Many of the current transactions have this small component of equity but a high level of non-recourse funding available from hybrid firms and hedge funds. 

Keep your eyes and ears open to the new players coming into the franchise segment. These are not the traditional equity funds or lenders that we have frequently written about; instead, they are new hybrid investors/lenders that may create some interesting opportunities for the franchise business owner.