To Have And Have Not

A year ago, many articles were being written on the complete, and seemingly intractable, seizure in the capital markets. Lenders weren’t lending, and investors weren’t investing, for many reasons, but a central cause was their lack of certainty as to the value of their existing positions. The resulting lack of liquidity exacerbated the problem. (In simple terms, if no one else will bid on my position -- whether it’s an investment or a loan -- then it must not be worth the value I’d placed on it, n’est-ce pas?)

In the past several months, the situation has been improving for some parts of the world. Some significant transactions have been announced -- Papa Murphy’s, CKE Restaurants, and Fuddruckers among them -- and others have already changed hands, suggesting that both investors and lenders are once again putting their capital to work. And yet ... (You knew it was coming, didn’t you?)

I’ve had conversations in the past few months with a number of lenders, both because of some projects and clients and because it’s partly how I find out what’s happening. For purposes of this column, I don’t intend to name names, and in fact I plan to invite one or more of them to offer their own views in coming weeks. The aim this week, and in future columns, is to identify and discuss what’s become, at least in my eyes, a clearer dichotomy between the “haves” and “have nots” than at most times in at least the past two decades.

I’ll start with a tale of three recent clients. Each has multiple units, growth opportunities, and cash flow of at or just below $10MM per year. I’ll describe them briefly as A, B, and C, and I've changed certain details to mask their identities.

Key differences:

A owns real estate with a value somewhere around $20MM. Performance has slipped in the past two years due to economic conditions, and cash flow margins are below industry averages. A new management team has taken the first steps to effect a turnaround, and early results are promising. Little growth is planned, so the debt will not be used for expansion; rather, it’s primarily replacing a lender getting out of the business.

B slipped badly during the industry’s “boom years” (say, 2004-2007) due to poor management decisions. Under new owners since 2008, B has shown dramatic improvements, with continued positive performance as of this writing, but cash flow margins remain somewhat below industry averages. Little growth is planned, so the debt will not be used for expansion; rather, it’s primarily replacing a lender getting out of the business.

C absorbed some traffic declines in 2008-2009, but has consistently been profitable. More than either A or B, C has some near term growth opportunities; its margins, in fact, are above average, but it needs capital due to investment in staff and location required by the growth opportunities, which should nearly double its size in coming years.

Oh, yes ... ownership. Of the three, A is owned by a wealthy individual; B is a stand-alone entity, but it is owned by a foreign operating company with attractive income streams but an ugly balance sheet; and C is jointly owned by the founders and a private equity fund.

Without getting too specific on the details, let’s just say that each of the three is viewed as a less than pristine opportunity by most lenders, but for very different reasons, and with very different results.

A was offered financing which approximately equates to the value of the owned real estate. The lender, of course, would take the real estate as security, as well as placing a lien on the brand and all other assets of the business, but would give no credit to the business vale beyond the real estate. Obviously, the weak performance has made it a riskier loan, but the recent upticks have earned the borrower no credit. The pricing would be roughly in line with bank financing for other cash flow businesses -- around 9-10% interest.

B was offered financing of approximately 1x its trailing cash flow, but with some limitations on usage which could be removed if (and only if) performance continued to improve, so that the lender was never exposed beyond 1x cash flow. The pricing would be roughly in line with bank financing for other cash flow businesses -- around 9-10% interest.

C was offered financing of over 3x its trailing cash flow, with limitations on usage but with the additional option of another 1x cash flow for further growth financing. the pricing was layered, with about one half in line with bank financing for other cash flow businesses -- around 9-10% interest; the rest at mezzanine or subordinated debt levels -- partially cash pay, partially in contingent interest or an equity slice so that the blended cost was about 21%.

What’s the difference? Size is not the distinguishing factor here. (We’ll discuss the size issue in an upcoming column.)

Clearly, C’s attractive margins (above industry averages) should give the lenders a feeling of safety relative to A or B. However, C’s riskier growth plans mean that much of the debt will be funding unit growth. Obviously, the pricing on the debt suggests that the lenders took that into account, but they also factored in something else. Both A and B were told (more than once) that they were unattractive to many lenders because they did not have private equity backing.

This is a fascinating development, and we’ve seen it play out in several industries over the past two or three economic cycles. Lenders will often be more aggressive for a borrower which has private equity ownership than for one run by the founder or a strong management team on behalf of an investor. There’s logic in this difference -- isn’t there? Stay tuned for further discussion, and (I hope) commentary from lenders, investors, and operators on all sides.