Preparing for the Tight Credit Market

The franchise world (particularly franchisee expansion development) is driven by the availability of credit. We have seen significant cycles over the years, from easy credit in the mid through late 1990s to the proliferation of lenders into the franchise market using securitized lending and then the withdrawal of those same lenders. There seems to be a constant battle to make sure there is enough available credit for the franchise industry.

The latest cycle is the overall tightening of the credit markets which will cause a significant ripple effect into the franchise space. The July 27, 2007 The New York Times Business Day article by Andrew Ross Sorkin and Michael J. de la Merced titled “Bam! Easy Credit Evaporates, and So Does the Buyout Frenzy” is one of many recent articles about the tightening of the credit market. We have seen the recent issues regarding Landry’s failure to file their SEC reports which resulted in lenders calling their loans; most likely these loans had favorable rates and were significantly under current market rates. We have also seen deals that have been put on hold. For example, the Cadberry Schweppes deal (which was a sale of its soft drink business to a private equity group) was put on hold due to the tightening credit market.

Private equity firms and buyout groups have been major sources of equity for the franchise space. As such, what is happening to the economy at large is very relevant. Public private equity groups (such as Fortress Investment Group and Blackstone Group) have seen their share prices erode because their lifeblood, like the franchise industry, of readily available credit is drying up.

The franchise industry, particularly franchisee lending, has always been seen as somewhat risky because of the lack of collateral and cash flow basis of these loans. It appears that these types of loans will be the first ones hit. It is extremely ironic how fast things change in the franchise industry. Last month’s column was on effective securitization using effective debt that was utilized by both Dunkin’ Brands and IHOP. As we know, from the recent announcement of the IHOP acquisition of Applebee’s, IHOP will have a significantly leveraged transaction by securitizing the cash flow of Applebee’s for the cash acquisition. I question if this debt will be available at attractive rates.

What can you, as a franchise business owner, do to protect or insulate yourself from this credit tightening?

Allow yourself additional time to get the deal done if you are planning an acquisition. Lenders will push for tighter due diligence, stricter compliance on collateral and documentation, and do extensive sensitivity testing to make sure there is enough room in your projections and proforma analysis to withstand a downturn in sales and potential changes in the economy.

Make sure you have substantial available liquidity. If there are problems, you can always pay down debt and have options that will buy you time to allow for a refinance or make a deal with the lender and covenant compliance.

Discuss extensions and options with your lender early on concerning your existing loans rather than waiting until the last minute with the thought that the lender will always extend your loans. Landry’s certainly wished they had dealt with their lenders sooner rather than later.

Make sure you keep contact with all available lending sources. Let them know your plans, that you are interested in having a relationship with them and keep your options open.

Do not forget about private individuals. Wealthy individuals are always looking for opportunities to invest and that investment may include loans. With the increasing interest rates, individuals may look at commercial type loans as a viable investment opportunity.

Do monthly proforma testing of your loans’ covenant compliance. If you anticipate future problems, go to your lenders right away rather than asking them for a covenant violation waiver. Right now you must be pro-active with any lender issues. With the tight credit market lenders may want out of their favorable rate loans and call your loan because of a covenant violation (which is within their legal right).

Look at the problems and issues behind declining prices for businesses. As the credit market tightens up in the franchise world, prices will begin to come down for franchise businesses. This may create great opportunities for potential buyers as long as they have available the credit.

Look to portfolio companies as both your lender and equity source. Look for groups that have to get their money out into the marketplace for appropriate returns. These types of groups would include hedge funds, the private investment world of the investment banking firms, and sources other than banks and finance companies.

In conclusion, make sure you are looking at all of your options, you fully understand your position with your lender, allow yourself additional time to close if you are in the process of a deal (which means going back to the seller and asking for extensions, as necessary), and be opportunistic about the pricing opportunities that may come up with a tighter credit market.