Time for Lenders to Reboot Their Franchise Finance Operations

Dec 4, 2023 | Insights, Restaurant Research

The restaurant franchise finance asset class currently benefits from strong unit-level sales and food cost deflation. Loan collateral has held up well generally speaking and the economy & capital markets are certainly stronger than the Great Recession that started around 2008. In this post, we conduct a Q&A with the head of a prominent franchise finance group & present some supporting data about why it may be time for lenders to jump back into the pool.  

Q&A with an Anonymous Head of a Prominent Franchise Finance Lender

1. According to the data presented below, industry closure rates for the $1B+ chains have been manageable (averaging just 2.0% annually over the last 20 years for the $1B+ Chains). Apart from some post-covid weeding-out of older stores in outdated markets, it seems like restaurant store collateral has held its value.

Aggregate Unit Closure Rate Graph

How has your loan portfolio performed?

QSR store collateral has largely held its value.  That being said, certain concepts experienced declines in purchase multiples as a direct result of EBITDA margin compression which we believe will reverse itself at some point.  In addition, our borrowers continue to be both vigilant and proactive in terms of assessing their store performance and seeking to either relocate or close some stores to enhance their financial condition. Closures typically come with some immediate financial obligations but, longer term, will enhance consolidated cash flow. 

Our loan portfolio performance is solid as we focus largely on QSR and intentionally diversified across brands, geographies, and collateral types.  Out of 150+ customer relationships in our loan book we have only one that is in arrears on loan payments at this time.  

2. Let’s start with sales. According to our data below, restaurant industry sales have increased +6%/year on average during the last 20 years, outperforming the +4.4% total retail average. Notably, there have only been 2 down years for the restaurant industry (2009 & 2020) which reflects that consumers are hesitant to cut out trips to their favorite restaurants (which represent an affordable luxury) except in extreme circumstances, and then sales quickly bounce back.

Industry Sales Growth Graph

Are you satisfied with the top-line performance of the stores in your portfolio?

We are satisfied with the top-line performance of our largely QSR store base in our portfolio as most, if not all, of the brands we focus on reported same store sales growth during the first half of 2023 and ongoing data continues to suggest that sales patterns remain strong in the back half of the year. Many brands continue to be able to take menu pricing which is helping to offset traffic declines and maintain EBITDA margins despite continued inflationary pressures, albeit moderating. The key will be their ability to continue to take price until such time as they can generate positive traffic and gain cost efficiencies across their businesses. The operating environment is challenging but these brands and owner-operators are resilient.

3. What is your outlook for the 2024 unit-level profit performance of your portfolio?

We anticipate that unit level profit performance will continue to strengthen in 2024 as borrowers continue to take price as available and gain further efficiencies in their businesses.  This week, one large QSR burger franchisee told me that his sales are up this year due to traffic increases despite not taking any price. Traffic growth is being driven by enhanced delivery and store hours.  Notably, delivery sales are bringing high average checks that allow him to maintain margin across the business.

4. Tell us a little bit about how your loan portfolio is performing in terms of the credit ratios you use to monitor them?

During 2022 we experienced some negative migration in our monitored credit ratios but much of that has reversed itself as we moved through 2023 (according to reviewed YTD and TTM financial statements). Same store sales growth and a moderating cost profile led to higher EBITDA margins and improved financial metrics.  We witnessed a higher level of post-compensation FCCR covenant defaults that were driven largely by the distribution of perceived excess cash off of customer’s balance sheets. Liquidity for our portfolio customers broadly remains very strong and cash flow coverage ratios continue to improve.  Overall, the primary sources of repayment continue to be solid.     

5. Do you agree with our assessment that it is time for lenders to re-engage with the franchise finance space? Can franchise finance players still make money in this space even with higher interest rates?

This is the right time for lenders to re-engage in the franchise finance space as there is an opportunity to generate satisfactory risk adjusted returns while expanding their share of wallet into other areas including deposits, treasury management services, capital markets products and even private client services. After being spoiled by a near zero interest rate environment, borrowers will realize that they can pay more for debt as long as they can generate acceptable ROIs in their businesses. There was a time in this business when the average loan coupon in our portfolio approximated 8.50% and business was as brisk as ever.

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