Franchise loan securities are a hybrid between the commercial mort- gage-backed securities (CMBS) and ABS markets. They are often backed by real estate, as in CMBS, but the deal structures are more akin to ABS.
Also, franchise loans resemble Small Business Administration (SBA) loans and CDOs more than they do consumer loan-backed ABS securi- ties. Greater reliance is placed on examining each franchise loan within the pool than on using aggregate statistics. In a pool of 100 to 200 loans (typical franchise loan group sizing) each loan is significant. By contrast within the consumer sector, any individual loan from a pool of 10,000 loans (as in home equity deals) does not represent as large a percentage, thus is not considered quite as important.
Franchise loans are similar to SBA loans in average size, maturity and end use. But whereas most SBA loans are floating rate loans indexed to the prime rate, most securitized franchise loans are fixed rate; if they are floating, they are likely to be LIBOR-linked. Franchise loans are used to fund working capital, expansion, acquisitions and renovation of existing franchise facilities.
The typical securitized deal borrower owns a large number of units, as opposed to being a small individual owner of a single franchise unit.
However, individual loans are usually made on a single unit, secured either by the real estate, the building, or the equipment in the franchise.
The consolidation within the industry and the emergence of large operators of numerous franchise units has improved industry credit per-
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formance. A company owning 10 to 100 units is in a better position to weather a financial setback than is the owner of a single franchise location.
Loans can also be either fixed or floating rate, and are typically closed-end, fully amortizing with maturities of 7 to 20 years. If secured by equipment, maturities range from 7 to 10 years. If they are secured by real estate, maturities usually extend 15 to 20 years. Interest rates range from 8% to 11%, depending on maturity and risk parameters.
Security Characteristics
Because franchise loan collateral is relatively new to the ABS market, and deal size is small, most of these securitized packages have been issued as a 144a private placement (Rule 144a of the Securities Act of 1933 governing private resales of securities to institutions). Issuers also prefer the 144a execution for competitive reasons, because they are reluctant to publicly disclose details of their transactions.
Deals typically range from $100 to $300 million, and are customar- ily backed by 150 to 200 loans. Average loan size is around $500,000, while individuals loans may range from $15,000 to $2,000,000.
Most deals are structured as sequential-pay bonds with a senior/
subordinate credit enhancement. Prepayments can occur if a franchise unit closes or is acquired by another franchisor. However, few prepay- ments have been experienced within securitized deals as of this writing, and most loans carry steep prepayment penalties that effectively dis- courage rate refinancing. Those penalties often equal 1% of the original balance of the loan.
Major Sectors
The vast majority of franchise operations consist of three types of retail establishments: restaurants, specialty retail stores (e.g., convenience stores, Blockbusters, 7-11s, Jiffy Lube, and Meineke Muffler), and retail gas stations (e.g., Texaco and Shell). The restaurant category has three major subsectors: quick-service restaurants (e.g., McDonald’s, Burger King, Wendy’s, and Pizza Hut), casual restaurants (e.g., T.G.I. Fridays, Red Lobster, and Don Pablo’s), and family restaurants (e.g., Denny’s, Perkins, and Friendly’s).
A “concept” is simply another name for a particular franchise idea, since each franchise seeks to differentiate itself from its competitors.
Hence, even though Burger King and Wendy’s are both QSRs specializ- ing in sandwiches, their menu and style of service are sufficiently differ- ent that each has its own business/marketing plan—or “concept.” For example, Wendy’s has long promoted the “fresh” market, because the firm mandated fresh (not frozen) beef patties in their hamburgers, and
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helped pioneer the industry’s salad bars. Burger King is noted for its
“flame broiled” burgers, and doing it “your way.”
In addition to segmenting the industry by functional types, it is also segmented by credit grades. For example, Fitch developed a credit tier- ing system based on expected recoveries of defaulted loans. Tier I con- cepts have a much lower expected default level than Tier II concepts, and so on. Many financial and operational variables go into these tiered ratings, including number of outlets nationwide (larger, successful con- cepts benefit from better exposure, national advertising, and the like);
concept “seasoning” (especially if it has weathered a recession); and via- bility in today’s competitive environment. (Yesterday’s darlings may have become over saturated, or unable to respond to changing tastes or trends by revamping and updating!)
Risk Considerations
There are several risk factors to be aware of when comparing franchise loan pools, and the following are some of the most important.
Number of Loans/Average Size
High concentrations of larger loans represent increased risk, just as in any other pool of securitized loans.
Loan-to-Value Ratio
LTVs can be based on either real estate or business values. It is impor- tant to determine which is being used in a particular deal in order to make a valid comparison with other franchise issues. Note that when business value is used to compute LTV, it is common for a nationally recognized accounting firm to provide the valuation estimate.
Fixed Charge Coverage Ratio
The fixed charge coverage ratio (FCCR) is calculated as follows:
Typical FCCRs range from 1.00 to 3.00, and average around 1.5. A deal with most unit FCCRs below 1.5 would be viewed as having greater risk than average, while one with most FCCRs above 1.5 would be perceived as having less risk than average.
FCCR Adjusted free cash flow less occupancy costs Occupancy costs plus debt service ---
=
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Diversification
As in all ABS sectors, a primary risk factor is the degree of diversification.
In a franchise loan deal, important areas for diversification include fran- chise owner, concept and location.
A typical franchise pool includes loans to 10 to 15 franchisees, each having taken out loans on 5 to 20 individual units. A large concentration of loans to any single franchise operator might increase deal risk. How- ever, such concentration is sometimes allowed, and rating agencies will not penalize severely if that particular franchisee has a very strong record and the individual franchise units have strong financials. It might even be better to have a high concentration of high-quality loans than a more diverse pool of weaker credits.
Concept diversification is also important. Franchise loans extend for 10 to 20 years, and a profitable concept today may become unprofitable as the loans mature.
It is not as important that pooled loans include representation across several major sectors (such as more than one restaurant subsec- tor, or loans from all three major groups). Many finance companies spe- cialize in one or two segments of the industry, and know their area well.
Thus a deal from only one of the major sectors does not add any mea- surable risk as long as there is diversification by franchisee and concept.
Geographical diversification is also important, as it reduces risk associ- ated with regional economic recessions.
Control of Collateral
A key factor in the event of borrower (franchisee) default is control of the collateral. If a franchise loan is secured by a fee simple mortgage, the lender controls disposition of collateral in a bankruptcy. However, if that collateral is a leasehold interest (especially if the lessor is a third party and not the franchisor), the lender may not be able to control disposition in the event of default.