Lending to the Brand Rather Than to the Company

The Structure

An ordinary corporate bond is a claim on a company. If the company goes bankrupt the holder of the bond is a creditor in its bankruptcy and competes with everyone else

a securitization of the entire company restructures that.The company transfers the assets that generate its cash flow to remote bankruptcy subsidiaries that issue the debt and those subsidiaries own the intellectual property franchise agreements and the right to receive royalties

The operating company continues to manage the business under a management agreement with the issuing entities and can be replaced if it fails to perform

The lender is therefore entitled to a defined stream of royalty payments from thousands of franchisees insulated from the parent company's fortunes

Why the Franchise Model Suits It

The structure requires cash flows that continue whether the current operator survives or not and franchising provides exactly that

What the Franchisor Actually Sells

Understanding the guarantee requires being clear about what the franchisor's business is because it is not the business customers think they are dealing with

The franchisor does not operate the points of sale does not employ staff does not sign property leases or purchase equipment. A franchisee does all this with its own capital. What the franchisor provides is the brand the operating system supply agreements and marketing and what it receives is a percentage of the franchisee's sales plus a contribution to advertising

That produces an unusual financial profile. Revenue is a royalty on someone else's income costs are largely fixed and corporate rather than variable and operating and the capital needed to add another establishment is provided by the person opening it. It's closer to a licensing business than a restaurant business

For a lender this is close to the ideal guarantee. Cash flow does not depend on margins at any individual location only on system-wide sales volume and is due contractually rather than earned each morning. It is also why the same structure has appeared wherever that profile exists and nowhere where it does not exist

Why the Debt Is Cheaper

Isolation produces a rating well above the parent's corporate credit often several notches substantially reducing the cost of borrowing

It also allows for much higher leverage. The transactions have been executed with leverage multiples that would not be available in the corporate bond market because the lender is underwriting a royalty stream rather than an operating business

The exchange for the borrower is a package of restrictive covenants. Cash flows through a defined waterfall managed by a fiduciary with reserves funded prior to any distribution to the parent and performance triggers that divert cash from the parent to accelerate debt repayment if metrics deteriorate

It's worth imagining the waterfall specifically because it's what makes the qualification possible. Royalties don't flow into the business. They flow into an account controlled by a manager who applies them in a fixed order each period: the structure's administrative and service costs then interest then scheduled capital then funding reserve accounts held against future payments and only then what's left for the parent company. The business owner is the last person who gets paid each month through a mechanism he or she doesn't control

The most important of these is usually a debt service coverage ratio test. Falling below a threshold traps the cash and falling further can trigger a rapid payback event

How the Coverage Test Behaves

The coverage ratio is where the risk of the structure really lies and it is worth analyzing its behavior because it is more sensitive than the headline number suggests

Let's take a system that generates 100 royalties against 20 corporate costs leaving 80 available with debt service of 50. The coverage is 1.6 times which sounds comfortable

Now suppose system-wide sales fall 15 percent. Royalties fall with them to 85 and the corporate cost base does not because head office marketing infrastructure and the cost of supporting franchisees are largely fixed. Cash on hand falls to 65 and coverage falls to 1.3 times. A 15 percent drop in sales produced a much larger drop in cushion

If we take it to a 30 percent decline royalties will be 70 cash on hand will be 50 and coverage will be exactly 1.0 times meaning every dollar of cash flow will go to the lenders and nothing will make it to the parent

That amplification is the operating leverage within a seemingly simple royalty stream and is the reason why the covenant thresholds sit well above 1.0. By the time the hedge approaches the structure has already stopped distributing to the owner and the capital of the transaction has effectively been suspended

What the Structure Protects Against

The remoteness of bankruptcy is the essence and is achieved through several features rather than one

The transfer of assets must be a real sale rather than a secured loan so the assets are no longer actually owned by the parent estate

The issuing entities have independent directors whose consent is required to file for bankruptcy which prevents a parent from voluntarily dragging them along

Your organizational documents contain separation agreements requiring them to maintain separate books accounts and identities so that a court will not consolidate them with parents

Those provisions are the difference between the structure operating and not and are the subject of legal opinions issued at closing

The replacement right deserves more skepticism than it usually receives. On paper a failed manager is removed and a replacement takes over collecting royalties. In practice the manager maintains franchisee relationships operational knowledge supply agreements and people and a brand in difficulty enough to prompt a replacement is not an attractive task. The right is real and has been exercised and is a mechanism for an orderly transition rather than a guarantee that cash flow will not be affected. The protectionThe lender's genuine claim is that the royalty obligation falls on thousands of franchisees who want to continue operating not that a successor manager is waiting

Where It Has Been Used

The technique was developed in the United Kingdom for pubs and adapted in the United States primarily for restaurant franchisors

Several large quick-service restaurant brands have been substantially or entirely funded through this structure and it has extended to fitness franchises car wash chains and other asset-light royalty businesses

Private equity owners have been enthusiastic adopters because the increased leverage available supports greater dividend recapitalization than corporate debt would allow which is a substantial part of the structure's growth

Whose Interests the Leverage Serves

This last point deserves to be mentioned rather than left out because it explains why these transactions are made in the size that they are

A dividend recapitalization is a transaction in which a company borrows money and pays it back to its owners. Nothing is purchased nothing is built and the company is left more in debt than it was.The owner has converted part of a future flow into cash today

Securitization of entire companies is unusually well-suited for this because the higher rating and greater leverage allows for more debt to be raised against the same cash flow than corporate financing would allow. The additional borrowing capacity created by the protections of the structure goes in a substantial number of cases to the shareholder and not to the business

Here it is also worth thinking about the franchisees since they are the ones generating the royalties. A more indebted franchisor has less ability to invest in the brand finance remodeling programs or support struggling operators during a crisis and has a greater incentive to increase system sales in a way that increases royalties without necessarily increasing the profitability of the franchisee. Those interests are not identical and the debt makes them less identical

The Risks the Rating Does Not Remove

Isolation protects against parental failure. It does not protect against business failure

If franchisees close royalties fall and no legal structure recovers them. The risk of concentration is therefore in the brand and the system rather than in a single entity

Specific exposures include declining same-store sales across the system deteriorating franchise profitability to the point where units close brand damage due to a food safety or reputation event and concentration of a system on a single geography or format

The diversification argument is weaker than the franchisee count implies which is the point most likely to be misunderstood. Thousands of operators sound like thousands of independent credits. They all sell the same product under the same brand in a similar format so what would prevent one of them from paying is largely what would prevent all of them from paying. What the numbers protect is the failure of any individual operator which was never a risk. The risk is the brand and in that exhibition the structuremaintains a single non-diversified position

The refinancing profile also matters. These transactions usually have an early payment date well before the legal maturity with a substantial increase in interest if they are not refinanced. This effectively makes them instruments with shorter maturities that require access to the markets on a schedule

The Refinancing Date Is the Real Maturity

This last point is understated in the way it is usually presented and is the feature most likely to cause problems

The legal maturity may be decades away and the expected payment date may be a few years away. If the debt is not refinanced by then the interest rate rises dramatically and excess cash is typically diverted to pay off the notes instead of reaching the owner. Neither is a default and both are serious enough that borrowers consider the earlier date to be the true one

What that means is that a transaction structured to survive the failure of its own servicer is still dependent on the credit markets being open on a particular date a few years from now. Bankruptcy's remoteness thoroughly addresses company-specific risk and does nothing about market-wide risk and a refinancing date that arrives during a closed market is a problem the legal structure was never designed to deal with

It also combines with the previous operating point. The moment a system's sales weaken is when refinancing is harder to obtain and more expensive so the two risks tend to arrive together and not independently

What to Look At

For anyone evaluating one useful measures are system-wide sales rather than franchisor revenue since the royalty is a percentage of the former; unit counts and net openings which indicate whether the system is growing or contracting; profitability at the franchisee level is disclosed as unprofitable franchisees eventually go out of business; and the coverage ratio versus their activation levels

Net openings deserve special weight because they are the closest thing to an independent verdict on the brand. Opening a store is a decision made by an operator committing its own capital with access to the real unit economics of the system and a system in which experienced franchisees refuse to open more units is being evaluated by the people best placed to evaluate it

The Bottom Line

Full corporate securitization separates a royalty stream from the company that manages it resulting in a higher rating cheaper debt and significantly more leverage than corporate financing would support. It works because franchise royalties come from thousands of independent operators with long contracts and would survive a change in management. What you can't isolate is the brand itself which means the entire structure depends on keeping customers coming into the restaurants and no package of covenants protects them against notdo so.It also does not isolate the refinancing date which is the only obligation that the structure returns to the market