Moving into the fourth quarter—historically the busiest time for franchise M&A and financing—optimism is fading for an end-of-year rush of successful deal activity. 2022 will be remembered as one of the most challenging environments franchisees and multi-unit brands have ever experienced. Unfortunately, these difficulties come after years with different but equally challenging factors. Brands and franchise owners, lenders, investors, and suppliers ask, “When can we catch a break?”
California’s FAST Act
One issue concerning both buyers and sellers is the recently passed legislation in California (AB 257 or the FAST Recovery Act) mandating higher minimum wages, benefits, and working conditions for many QSR operators. Under this, minimum wages in California could increase up to 50% in January 2023, to $22.50. While the industry will likely support a referendum delaying implementation until 2025, the legislation may curtail deal activity in California for the foreseeable future. While this targeted legislation excludes most franchise owners, operators who are affected may see an immediate impact on valuations and transactions. Additionally, there are concerns that similar legislative efforts will spread to other states.
Interest up, capital down
In addition to minimum wage efforts, higher interest rates and the availability of capital are affecting transactions to a greater degree. Interest rates have doubled over the past year, additional increases are expected for at least the balance of the year, and the availability of capital has decreased as the economy teeters on recession. Capital providers are reducing loan advances, underwriting requirements are tightening, and equity requirements are increasing.
Availability is also constrained by growing covenant and payment defaults on existing loans. As margin pressures reduce profitability, more operators are finding themselves in covenant default or in danger of default, adding additional pressure to financial institutions and operators. Development and remodeling capital is often cut, putting pressure on operators to use cash reserves to complete projects. The situation is compounded in Tier II and III brands, where capital is harder to secure. In M&A transactions, alternatives to traditional financing are becoming more prevalent. Buyers with committed capital will have an advantage in the current environment, as sellers place increasing importance on a buyer’s ability to close.
Declining trends, margin compression
Operators across the industry have been affected by rapidly increasing costs and labor issues, which, in turn, affect transactions. Covid-related add-backs and other adjustments to EBITDA for one-time expenses are no longer credible. Many sellers still think they can market their business based on 2021 results. Buyers look at current performance as a baseline against 2019 and, in many cases, factor in another six months of margin compression when evaluating acquisition opportunities. The inability to forecast accurately also sidelines many industry consolidators that either have their own operational challenges, or are waiting for a more stable deal and operating environment. Sellers contemplating a transaction should address margin pressures and outlook up front, manage surprises, and guard against re-trading because of declining trends and cost pressures.
Gaps in valuation expectations
These differing expectations promote an increasing gap between buyers and sellers. Sellers contemplating deals in the current environment should be prepared to get creative to bridge this gap. With traditional capital availability constrained, both buyers and sellers should review other alternatives including seller paper, non-bank lenders, earn-outs, and rollover minority equity positions to complete deals. We expect the valuation gap to widen through the balance of 2022, as margin pressures and interest rate increases show little sign of abating in the near term.
Brand activism
Brands, especially Tier I restaurant concepts, continue to play a key role in the approval or rejection of transactions. Franchisors continue to “steer” transactions to favored franchisee buyers—especially when the brand has a financial incentive in the completion of a transaction. Frequently, a transaction is inked between buyer and seller only to be rejected or modified at the franchisor level for a host of reasons. As sellers prepare to market their businesses, anticipating franchisor obstacles is critical to success. This is often a Catch-22, as sellers may want to avoid communicating a transaction with a franchisor until the asset purchase agreement is executed and presented in order to avoid brand influence. With the current activism in many brands, this strategy can backfire if the brand has issues with the buyer or prefers an alternative buyer for the units. The best practice is to have a backup buyer in mind if problems are anticipated.
Deal timing and delays
The adage “time kills deals” has never been more accurate. With rapidly rising costs, interest rate swings, geopolitical developments, and government intervention in franchising, completing transactions on an accelerated timeline has never been more critical. How can sellers keep transaction timetables on track?
Landlord relations are critical for receiving timely consent and lease assignments. Solid relations and communication saves time in the closing process and minimizes last-minute landlord demands. Additionally, sellers or their counsel should prepare initial forms of LOI, APA, and other documents in advance. Before marketing your business, ensure that all documents are in order, including financial statements, leases, and franchise agreements.
Control what you can
As we conclude 2022, the path to the closing table has never been more strewn with obstacles. Minimize disruptions with focus and preparation on what can be controlled to increase the odds of a successful transaction.
Carty Davis is a partner with C Squared Advisors, a boutique investment bank that has completed hundreds of transactions in the multi-unit franchise and restaurant space. Since 2004 he’s been an area developer for Sport Clips in North Carolina with more than 70 units. Contact him at 910-528-1931 or carty@c2advisorygroup.com.