Securitization: A Big Opportunity For Franchisors

This article is truly a work in process about the technique of securitization. As I write about this month’s topic, there are significant pending transactions utilizing the franchisor’s cash flow and royalty streams as a collateral source for low interest debt financing which may further define this topic.

There has been a great deal of publicity around this topic and some of the major transactions; particularly, the Domino’s transaction (which was one of the first major transactions in this latest wave) and, more recently, the Dunkin’ Brands transaction.

The primary way these types of transactions are structured is through the use of special purpose entities (SPE’s) to hold the assets that generate the cash flow of the franchisor (either royalty streams or other sources of cash flow). This segregate cash flow is the key element for the sale of the bonds. This cash flow, along with an insured element, provides the needed security for the bond holders.

I recently had the opportunity to interview both Tom Conforti, the Chief Financial Officer of IHOP Corp., and Kate Lavelle, the Chief Financial Officer of Dunkin’ Brands, Inc. Both of these companies were involved in major securitized transactions.

IHOP. As we know, IHOP management has done a wonderful job of growing the company, and its stock is performing extremely well. In an effort to secure financing (to either use for the buy-back of their stock or for a potential acquisition), IHOP recently entered into a very successful securitization. What was unique about the IHOP securitization is that it was based on all of the cash flow of the company (i.e., the lease payments received from franchisees, financing given the franchisees, franchisee notes, cash flow from corporate stores, and even the sale of the pancake mix), not just the royalty streams. Every conceivable cash payment was the source of cash flow for the IHOP securitization.

Even though certain issues came up in IHOP’s securitization (particularly the quality of cash flow from some of the individual components of IHOP’s business), IHOP was able to package all of this together and place all of its cash flow into an SPE.

The uniqueness of IHOP’s transaction is that IHOP took the route of not going with an overly leveraged transaction. They could have received additional proceeds from the securitization – something approximating 7 times cash flow – but instead IHOP elected to go with 4.7 times. This, in turn, allowed IHOP to get wonderful performance of the bond sales. IHOP was able to sell the securitization as investment grade AAA paper. Also, by not trying to push the envelope, IHOP’s insurance costs related to the obligation’s insured factor were very reasonable.

Dunkin’ Brands. Kate Lavelle provided me with significant insight into the Dunkin’ Brands securitization. The owners of Dunkin’ Brands used securitization as an acquisition funding vehicle. Dunkin’ Brands consists of three different concepts; thus necessitating a different approach than the IHOP transaction. Additionally, the Dunkin’ Brands securitization was a highly leveraged transaction and had a very specific purpose of acquisition funding. Much like IHOP, Dunkin’ Brands securitized all of its cash flow. They used different special purposes entities: (1) for each brand and (2) for their real estate. These special purpose entities all came under one umbrella. This umbrella entity is the entity that was utilized to issue the bonds based upon the cash flow. Like IHOP, Dunkin’ Brands was able to get tremendous performance. They were able to raise $1.5 billion as AAA rated bonds and $100,000 through the issuance of uninsured subordinate notes.

The insurance products which accompany the high grade bonds will provide ultimate protection to investors. Further, the insurers are only willing to provide appropriate insurance at an AAA level if the company is solid and clearly able to perform the repayment process.

One big issue is the compliance process, which I discussed with Kate. She said in the beginning, the weekly compliance was a challenge, but by the time of the first monthly reports, they were able to work through this process effectively. They are now in the process of going online with an automated compliance process.

Both Tom and Kate stressed their company’s securitizations allowed for advances of additional funding in the future and provided a significant amount of flexibility at a very attractive rate which made the legal and investment banking process worth the cost. With this type of resounding support by both Tom and Kate toward securitization, it is clear the securitization process is here to stay and will be utilized by many other franchisors.

The securitization and repayment of the bonds are all administered through a master trust arrangement. The trustee takes charge of all of the cash flow coming in. There is a disbursement account so that the borrower (for example, IHOP) can service all of its ordinary operating obligations and then the current obligations under the bonds. This seems like a fairly onerous approach but, in most cases, this is fully automated and rather seamless to the borrower.
There are a number of other key components to securitization, such as the purchase of various swap obligations and other types of capital instruments engineering which can be complicated. But, again, the key to effective securitization is not pushing the envelope, getting very good performance by not having an over-leveraged situation, having strong technology and, finally, to really do effective internal auditing so the transaction anticipates the issues that may come up and addresses those concerns.

Other franchisors are now in the process of proceeding with securitizations. Securitization is a complicated transaction and requires significant financial engineering and legal expense. However, it does seem to be the way of the future for the franchisor. We have yet to see securitization evolve back to the franchisee’s side, but we do know the franchisors are going to significantly utilize securitization in the near term.