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It’s Still a Good Time to Sell, Refinance or Recapitalize Your Business
December 2007 Franchising World
Headlines can be misleading, but the sky is not falling and it is still a very good time to sell, refinance or recapitalize a business. By Thomas Lauer It is difficult to pick up a newspaper or magazine these days without reading about the dramatic changes taking place in the global financing markets. In March, many heard about a dramatic sell-off of U.S. subprime mortgage assets on fears of rising homeowner defaults. In June, readers learned that several prominent hedge funds had suffered heavy losses related to credit-backed securities. In August, the news was that global investment banks were sitting on a backlog of more than $330 billion in private-equity sponsored leveraged buy-out loans for which they could not find buyers. And in October, the International Monetary Fund warned that the U.S. credit crisis could affect global economic growth in 2008 and beyond. The bad news seems to keep piling up, and many industry observers are claiming that the country is in the midst of a severe credit crunch and that the end of the “golden age of private equity” has arrived. So what does this mean for the owners and managers of small- and medium-sized, franchise-based businesses? Is it too late to sell a company at an attractive valuation or to pay a dividend to shareholders? Should owners wait another two or three years for conditions to improve before raising the capital needed to grow the franchise system?
The Lower Middle Market
The Cost of Capital
Franchise-Based Business Models
Professionalize Your Business
Demonstrate the Ability to Scale
Continue to Invest in the Business Thomas Lauer is managing director of Allied Capital. He can be reached at 312-846-5121 or tlauer@alliedcapital.com.
Consider looking past the headlines and focus on several important reasons why now might still be a very good time to consider making the next financial move.
When it comes to raising money, the type and cost of available options is driven by the size of the company. Normally, large companies have the ability to draw from deep pools of low-cost capital while small- and medium-sized companies rely on fewer, more expensive providers. However, in today’s market conditions, large businesses find themselves with fewer financing alternatives than smaller companies. This is partly due to the fundamental structural differences associated with each of these two markets.
In the large corporate market, debt and equity issuances are underwritten by investment banks and highly-structured to appeal to the broadest group of investors possible. Buyers of these liquid securities are primarily portfolio managers, who make investment decisions based on the underlying credit quality of the issuer (company risk), as well as relative pricing trends in the market (market risk). When secondary market prices decline due to credit concerns or general market fears, portfolio managers respond by selling their existing positions and lowering their demand for new investments. Although this is a very simplistic explanation, it may help one to understand why liquidity can quickly dry up in the large corporate market thereby creating the “credit crunch” reported by most media outlets.
In the lower-middle market, transactions are largely financed by buy-and-hold investors who make capital allocation decisions based solely on the merits of each company (company risk only). Investments are priced to achieve specific risk-adjusted returns, offer very flexible, customized terms, and are seldom, if ever, sold. Even larger transactions in this market are “clubbed” together among like-minded investors, thereby eliminating syndication risk. As a result, changes in market conditions have a limited affect on the amount of capital available to these businesses. As long as default rates remain low and companies in the lower-middle market continue to perform, investors will actively seek new opportunities to deploy capital.
Another factor to keep in mind is that the lower-middle market has seen a substantial increase in the number of debt and debt-like capital providers focused on smaller companies. Sophisticated investors are realizing that even though risk increases as revenue level decreases, there are many good small- and medium-sized businesses with attractive profiles, companies with strong positions in niche markets, good management teams that react quickly to changing environments and faster growth opportunities than larger competitors. Essentially, as long as the opportunity exists for investors to earn attractive risk-adjusted returns, they will continue to invest in this market.
Within the financing industry, the relative cost of capital can be measured by enterprise values and debt levels expressed as a multiple of earnings before interest, taxes, depreciation and amortization. Higher multiples are good for sellers and borrowers, but often result in lower than expected returns for investors. In Figure 1, one can see the average historical purchase price multiples and debt levels achieved by middle-market companies over the past 10 years (note that the average EBITDA of companies measured by this data is ~$30 million). Over the past five years, and more specifically over the past 24 months, a dramatic increase has been seen in the price levels and amount of leverage available to middle market companies.
There are several reasons why these multiples have surged to record levels. The U.S. economy has grown with relatively few “hiccups” over a prolonged period; there has been a substantial increase in the amount of capital allocated by pension funds, endowments and foreign governments to private markets; company owners are increasingly aware of exit alternatives, and as discussed in the previous section, the number of providers and availability of inexpensive capital in the middle market has grown dramatically.
There is another measure of cost of capital—the percentage over the London Interbank Offering Rate paid to traditional senior debt lenders in the middle market. This metric is closely watched by most banks and debt investors, and as indicated in Figure 2, prices are near historical lows.
Obviously, there are many factors specific to an individual company that will determine what a buyer is willing to pay or the cost at which an investor is willing to lend. It is also important to remember that smaller companies usually trade at lower levels than those demonstrated in the charts in this article. Nevertheless, the point of providing this data is to illustrate that within the context of a longer historical period, overall pricing conditions within the middle market (and the lower-middle market) are still very favorable.
As readers know, the franchising industry continues to gain momentum each year, accounting for a growing percentage (3.9 percent) of U.S. private-sector output, according to the International Franchise Association’s Policy Digest. Intended for lawmakers, the digest summarizes the findings of the Economic Impact of Franchised Businesses study that was conducted by PricewaterhouseCoopers. As a result, the number of middle-market private-equity groups and lenders that specialize in this industry have also increased each year.
From a capital provider’s perspective, franchise-based business models represent very attractive investment opportunities given their recurring revenue streams, strong brand names, unit diversification (geography and franchisee), low-capital investment requirements, and high free-cash flows (this assumes a clean history with respect to franchisee litigation). These characteristics appeal to both equity and debt investors and as a result, owners or managers of these types of businesses should be able to attract a high degree of interest when looking to raise capital.
For those franchise business owners and managers who seek to distinguish their companies with investors in an increasingly competitive industry, here are a few ideas to consider:
As the franchising industry matures and concepts continue to grow in size and scale, franchise systems must attract strong management teams and create more formalized business processes. Owners should recognize that there is substantial benefit to investors by running their companies less like “family-owned” organizations and more like professional corporations.
Franchise companies that demonstrate growth along several different paths–perhaps through new units, new concepts or acquisitions–or have established and managed holding company structures that leverage fixed costs and share best practices, will be very highly-valued by prospective investors.
There are many older concepts with strong brands in the industry these days, and it is important for management teams to demonstrate to investors that they have the ability to stay true to their concept roots while simultaneously keeping their product or service relevant to today’s consumers and providing good unit economics for franchisees. This may mean investing in new technologies, introducing new products or bringing in fresh management.
The macro environment for lower middle-market companies is still very positive. The cost of capital is still relatively attractive when compared to historical levels and franchise-based businesses are well-positioned to attract an increasing number of knowledgeable capital providers. Headlines can be misleading, but the sky is not falling and it is still a very good time to sell, refinance or recapitalize a business.
