If Roark Capital completes its acquisition of Subway for roughly $9.5 billion, the deal will embody almost $5 billion of debt, offered by a bunch of a number of banks working collectively. This can characterize one of many largest entire enterprise securitizations (WBS) ever accomplished. Subway has round $725 million of EBITDA to assist debt funds. Roark is maybe the foremost in franchising WBS transactions, having repeatedly returned to the market utilizing this method throughout a lot of its different holdings to fund growth initiatives and dividend payouts.

Satirically, Subway’s CEO, John Chidsey, not too long ago mentioned debt in his primary stage remarks on the annual Restaurant Finance and Growth Convention in November 2023, which I attended. He talked about that he was grateful for having no debt whereas the enterprise was privately held as a result of the additional money circulation could possibly be dedicated to the enterprise, and he did not have to fret about debt service.

Associated: Contemplating franchise possession? Get began now to search out your customized listing of franchises that match your life-style, pursuits and price range.

What’s entire enterprise securitization?

Entire enterprise securitization is debt supported by working belongings, corresponding to franchise royalties and provide chain rebates. During the last fifteen years, there was a large shift towards this capital construction method within the largest franchise manufacturers. WBS is an environment friendly method to borrowing cash as a result of the rates of interest could be decrease. Royalties are shifted into their very own bankruptcy-remote particular goal entity. Because of this, the entity can get pleasure from the next credit standing (and thus decrease rates of interest) in comparison with the mum or dad firm. Along with being capital environment friendly, it makes curiosity funds extra predictable, and there’s extra prepayment flexibility. The market could be tapped many times because the enterprise continues to develop. The debt is often transportable if there’s a change in management.

For these causes, WBS is now the popular construction within the largest franchise methods, whether or not publicly traded, PE-backed, or privately held. Whereas giant restaurant franchises are the biggest customers of WBS, the usage of WBS by non-restaurants expanded 75 p.c within the final 4 years, almost double the expansion charge of WBS within the restaurant sector. I cited this statistic, from Guggenheim Securities, in my guide, Huge Cash in Franchising: Scaling Your Enterprise within the Period of Personal Fairness.

Debt in franchising

Using debt in franchising has backed off the upper ranges beforehand seen when junk bonds have been in vogue many years in the past. The market has gotten comfy with securitization and prefers to see fairness investments approaching 50 p.c – in keeping with PE offers exterior of franchising.

There are a number of implications for stakeholders, particularly franchisees, in methods utilizing the WBS method:

• Preservation of outlet rely is paramount to the franchisor. For turnaround manufacturers like Subway, this implies an aggressive wager on worldwide growth to offset potential closures nonetheless to come back within the US.
• Growth markets will obtain investments in assist and franchise improvement to make sure all these new models get open and ramped up.
• Until a unit’s location is not viable, franchisors will typically battle closures and push for transfers as an alternative.
• The push for transfers as an alternative of closures in most giant methods, tends to extend PE consolidators on the franchisee degree. However Subway hasn’t attracted PE consolidators due to unit degree economics. Solely enchancment in unit profitability will open this potential.
• Switch necessities could also be extra stringent.
• Growth agreements might be extra strongly enforced.
• New improvement agreements might have smaller unit commitments to make sure follow-through.
• Franchisors will extra aggressively push remodels to protect and enhance royalties.
• Provide chain rebates may also be protected. Suppliers will discover it tough to make changes that negatively affect franchisor earnings streams if these have already been securitized.
• PE sponsors can withdraw tons of of hundreds of thousands of {dollars} in distributions from large-scale manufacturers typically by including debt to the enterprise. If there’s little or no company reinvestment in the way forward for the model, franchisees should converse up. That is finest managed in knowledgeable, coordinated, and assertive method through the impartial franchisee affiliation. Stall outs can and do happen when inertia creeps in and company milks money circulation too lengthy. Franchisees should proceed to say themselves through the affiliation to make sure shared reinvestment sooner or later.

Smaller franchises

Observe that in smaller franchise acquisitions, debt typically is not used in any respect. As PE has swept by means of franchising, there are fewer unaffiliated scale manufacturers out there to amass. The end result splits the gamers and their approaches. In bigger offers, decrease rates of interest not too long ago concurrently fed value inflation and inspired the usage of debt, together with securitized debt.

However smaller offers usually tend to be all-cash, particularly if tuck-in acquisitions inside multi-brand platforms. The bigger platform money circulation can at all times be securitized later when scale is achieved. Rising model PE sponsors are thus centered on accelerating progress, including assist infrastructure, constructing shared platform sources and, finally, a number of arbitrages to assist carry total enterprise valuation. Using debt isn’t a core technique to create worth for the sponsor in these offers. In principle, this creates a detailed alignment of franchisee and sponsor pursuits inside rising manufacturers and platforms.

Potential franchisees ought to assess the place a model is on the spectrum of exercise and the way a lot the usage of debt is a core a part of the worth creation technique for the sponsor itself. So long as applicable investments in the way forward for the enterprise are made, there’s nothing flawed with the usage of affordable debt in an environment friendly capital construction. However when mum or dad distributions considerably outweigh new investments within the enterprise in a fast-changing market, warning flags ought to be raised.