This article will appear in Franchising World magazine’s May issue in both print and digital editions.
Understanding How Capital Access Has Changed Financing
By Darrell Johnson, CFE
President and CEO
What a difference two years make. Remember preferred lenders? Today most prefer not to. The preferred lenders of yesterday have either cut way back on small-business lending or stopped such lending programs altogether. Since debt capital is critical to franchise growth, it’s important to understand what has happened, how long it will stay this way, and what you should do about it.
The dearth of active small-business lenders has little to do with franchising or even small business. To understand this, you need to understand the types of lenders that are out there.
Small-business lenders include deposit-based lenders, non-bank lenders and, to a much lesser extent, leasing companies. Deposit-based financial institutions include national banks like Bank of America and Wells Fargo, local banks and credit unions. Non-bank lenders include national institutions such as CIT and GE Capital, and smaller regional/local lenders like Wing Finance and Mt. Pleasant. Finally, there are lots of leasing companies.
Many of the bigger deposit-based financial institutions were significantly affected by their mortgage portfolios. When they were forced to write off the losses in their mortgage portfolios, they had less capital to lend to commercial businesses. Most of the deposit-based lenders still active are smaller, more locally-focused institutions that did not have much mortgage exposure.
In a cruel irony, today most depositary institutions have relatively low costs of capital and relatively profitable spreads to commercial lending rates; this should translate into more loans. The good news is with that wide of a profitable spread, local depositary institutions are lending and most of the bigger banks eventually can and will be able to earn their way back to health by lending.
The non-bank group depends on the capital markets for their money, and when the capital markets froze, this group lost its ability to borrow and to move existing business off their balance sheets, essentially stopping their lending activity in its tracks.
In all likelihood, it will take several years for the capital markets to get back to a point where they provide a regular flow of capital to non-bank lenders. That is why, in part, lenders like CIT chose to become depositary banks, gaining access to both TARP funds and deposits. Whether others follow suit, like GE Capital, has yet to be determined but you can bet they have looked into it.
Credit Departments Have the Upper Hand
Compounding the problems of lenders having sufficient capital to lend is the shift in perceived business lending risks. Lender willingness to lend is affected by the influence that credit departments exert from within. When the economy is in decline, credit departments become more conservative. The loan process is a balance between two competing forces: Putting loans on the books, which is how lenders make money (return), and using good underwriting requirements, loan structures, and terms, which is how lenders keep from losing money (risk).
CEOs of some of the largest banks in the country faced Congress in a committee hearing last month and were chastised for taking the federal government’s Troubled Asset Relief Program money and not lending enough. In varying ways, each responded that they were lending and would lend more. If the source of power in today’s lending decision process is the credit department, how likely is it that the spigot will open much wider before the economy starts turning around? The answer is “not very likely,” and “somewhat likely.”
For conventional loans (those where lenders have all the risk), any dramatic increase in lending is a ways off. However, for SBA loans, things are improving. Why? Because the government changed the risk/return relationship for SBA loans, something they can’t do with conventional lending.
Under the main SBA 7(a) program, loans had a 75 percent guarantee but Congress recently temporarily increased the guarantee percentage to 90 percent. That changed the risk dynamic and certainly encourages more SBA lending. Whether this anticipated increase in SBA loans will be enough to compensate for lost conventional lending remains to be seen, but it clearly will help. The banking crisis created some other challenges for the SBA lending program that Congress and the administration are addressing that will be factors as well.
So Where Does That Leave Us?
Small-business credit is tight and will continue to be tight for the next few years. How long?
To answer that, you need to think like a banker and view it from a credit department’s perspective. A credit analyst will look for two things before changing from a conservative “don’t lose money” mentality to a “we can start making money” mentality. First, economic conditions have to turn around and show signs of sustainability. Second, a credit analyst will want to see that the business being considered for a loan is able to show sustainable performance.
At that point credit terms will begin to ease--gradually. That can be at least two to three years from now. If that’s the time frame, what can be done in the interim so franchisors can expand with new units? Perhaps as importantly, what can franchisors do to encourage financing for transfers of existing units to maintain the perceived value of all units in their systems?
The answer lies in who to approach and what to approach with. Like famed bank robber Willie Sutton, franchisees need to go to where the money is, or in this case, where most of the money is being loaned: local lenders.
What Franchisors Must do to Encourage Capital Access
For most of this decade franchisors built preferred-lender relationships that they introduced to their franchisees. Redirecting their attention to local lenders can’t be done the same way, however. Preferred lenders looked at a brand ahead of possible loan opportunities because they anticipated doing lots of transactions. Local lenders don’t want to underwrite a brand until they have a loan to underwrite, so franchisors can’t approach them in advance. This gives franchisors only a short window of time to provide a package of information. What should that package contain?
Local lenders often don’t know have much franchise lending experience and very likely no experience with a particular brand. It comes down to assessing franchising risks. Before credit departments actually look at the borrower’s application, they have always needed to answer two threshold questions. First, are they comfortable with franchise lending risks? Second, what do they know about the performance of the particular brand? If they can’t answer “yes” to the first two questions, they will never get to the borrower’s application.
There are several risk assessment tools that are increasingly important today. The SBA Franchise Registry provides a dual benefit for lenders: It facilitates the SBA loan review process–a process which lowers risk to lenders automatically–and it validates that a brand is established and legitimate in terms of SBA requirements. Whether conventional or SBA-focused, lenders who don’t find a particular brand listed on the Registry see that absence as a risk issue.
The Franchise Registry is a necessary capital-access qualifier today, but it is not enough. Local conventional, as well as SBA lenders, face a conundrum. Today, credit departments demand more analysis for franchise loans. Yet it is likely that they will only do one or two transactions with a particular brand. Is it worth the extra effort? Perhaps the better question for franchisors is: why not have the work done for credit departments, and in the process control the type of analysis done, so that work doesn’t become an issue?
What do credit departments want to see? Well, what they don’t want to see the marketing information franchisors provide to prospective franchisees. They want to see information that assesses risks related to the franchisor and risks related to the franchise system. Absent being provided with good information, they are likely to take an uncertain and inconsistent path towards the analysis.
For instance, we are all familiar with the term “unit turnover” and we know that there is good, as well as bad, turnover. But a local banker’s reaction to turnover in a Franchise Disclosure Document is likely to be that it sounds bad and therefore probably bad. It’s better to have the analysis framed around the underlying risk issue, unit continuity.
An even bigger challenge is that inexperienced franchise lenders reach for easily accessible information, often without understanding how to properly use such information. A good example is SBA loss data.
Most conventional loan, SBA loan and leasing originators know to review such information, even though the data are often not accurate and hard to understand without additional information. The inaccuracies come from how lenders submit data to the SBA. While lenders are supposed to associate a franchise loan with a particular brand, they often fail to provide that information. Hence, SBA loans made to franchisees of a specific brand can be under-reported. Yet when a loan goes into default, usually input errors are corrected.
The result is that the number and dollar amount of loans in default, as percentages of total loans to a particular brand, can be overstated. A solution to this data problem is on the way but it will not correct past years’ data. Since the SBA reports franchise loan performance data in aggregate since 2001, franchisors should at least know how many of their franchisees have had SBA loans during that time period. The SBA currently does not have the ability to correct historical reporting, so having the ability to make representations to lenders about reported SBA data will improve a brand’s access to capital.
Further, SBA loan performance is only one factor related to system performance. In the absence of more detailed data from a peer group of franchise companies with which to compare a particular brand’s unit performance, credit departments are make lending decisions on minimal and often misleading information. A bank credit report should address the underlying risks that all of a brand’s unit performance data represent to a lender. (A more complete range of risks to be analyzed and further examples of such reports can be viewed on FRANdata’s Web site, www.frandata.com.)
Important Steps for Franchisors
Capital access challenges are going to affect every franchise system's unit expansion and unit transfers for the next few years. And it’s not just a greater focus on the franchisee borrower. Franchisor and system performance matter more in today’s lending environment. Here are some steps franchisors can take to navigate these challenging lending waters:
1. Think like a banker: How does the FDD read from a lending perspective? What other readily accessible information is there about a brand that lenders will be seeing? Is the brand’s Franchise Registry listing current? How does a brand’s system performance compare to its peer group? What are the lending risk factors associated with the franchisor and system that stand out? Can they be mitigated?
2. Have some of the lender’s work done for them: Find someone who understands lender language and lending risks. Add peer comparisons where appropriate.
3. Deliver the information at the right time: If the report contains information that raises disclosure issues (likely if there are risk issues to be mitigated), it can be given directly to lenders under a confidentiality agreement. If the report does not contain information that raises disclosure issues, the report can be given to franchisees and provides important brand validation (assuming good performance, of course). Either way, a bank credit report needs to get into the lender’s hands at the right time.
Gone are the days when franchisors could build relationships with preferred lenders in advance of expected loan applications and then heavily rely on preferred lenders to provide capital to franchisees. We are experiencing a paradigm shift in ways franchisors and lenders interact. Two years ago franchisors had lenders waiting in their lobbies. Today, franchisees are waiting in crowded lending lobbies. Adjusting to that new reality will mean a much greater likelihood of having access to capital. Then everyone wins.
Franchisor Capital Access Check List
1. Look at a brand’s performance from a lender perspective
2. Make sure the Franchise Registry listing is current
3. Have a Bank Credit Report prepared for lenders
4. Provide lender confidentiality agreements if needed
5. Be prepared to deliver information to lenders quickly
Darrell Johnson, CFE, is president and CEO of FRANdata Corp. He can be reached at