This financing method is key to the $9.5 billion metro deal

If Roark Capital completes its acquisition of Subway for roughly $9.5 billion, the deal would come with nearly $5 billion in debt provided by a group of several partnering banks. This might be one of the largest enterprise-wide securitizations (WBS) in history. Subway has about $725 million in EBITDA to cover debt. Roark is arguably the leader in WBS franchise deals because it has returned to the market multiple times, using this system with many of its other holdings, to finance expansion initiatives and pay dividends.

Ironically, Subway CEO John Chidsey recently discussed debt in his predominant stage remarks at the annual restaurant finance and development conference Conference in November 2023, which I attended. He mentioned that he was grateful to be debt-free while the company was private because the extra money flow could possibly be put towards the business and he didn’t have to worry about debt service.

What is enterprise-wide securitization?

Enterprise-wide securitization involves debt backed by operational assets reminiscent of franchise royalties and supply chain rebates. Over the last fifteen years, major franchise brands have seen a huge shift towards this approach to capital structure. WBS is an efficient approach to borrowing money because rates of interest may be lower. Royalties are transferred to its own special purpose vehicle away from bankruptcy. For this reason, the entity may enjoy higher creditworthiness (and due to this fact lower rates of interest) compared to the parent company. In addition to being capital efficient, it makes interest payments more predictable and provides greater prepayment flexibility. The market may be exploited again and again as the company grows. Debt is typically transferred upon a change of control.

For these reasons, WBS is now the structure of selection in major franchise systems, whether publicly traded, PE-backed or private. Although the largest users of WBS are large franchised restaurants, WBS use by non-restaurant entities has increased by 75 percent over the past 4 years, almost twice the rate of WBS growth in the restaurant sector. I quoted this statistic from Guggenheim Securities in: my book, Big Money in Franchising: Scaling Your Enterprise in the Age of Private Equity.

Franchise debt

The use of debt in franchising has regressed to the higher levels previously seen when junk bonds were in vogue a long time ago. The market has change into comfortable with securitization and prefers equity investments to be closer to 50 percent – which is consistent with non-franchised PE deals.

There are several implications for stakeholders, especially franchisees, in systems using a WBS approach:

• For the franchisor, the most vital thing is to maintain the variety of sales points. For disruptive brands like Subway, this implies aggressively pursuing international expansion to offset potential closures yet to come in the US.
• Expansion markets will receive investment in franchise support and development to ensure all recent units are opened and developed.
• Unless the location of the unit is not profitable, franchisors will generally fight against closing the units and insist on relocations as an alternative.
• The emphasis on transfers somewhat than closures in most large systems is increasing the variety of PE consolidators at the franchisee level. However, Subway didn’t attract PE consolidators due to unit-level economics. Only improving the profitability of units will unlock this potential.
• Transfer requirements could also be more stringent.
• Development agreements might be more strongly enforced.
• New development agreements may contain smaller unit commitments to ensure implementation.
• Franchisors might be more aggressive in pushing redevelopments to preserve and increase royalties.
• Supply chain discounts may even be protected. It might be difficult for suppliers to make adjustments that can negatively impact franchisors’ revenue streams if they have already been securitized.
• PE sponsors can money out tons of of hundreds of thousands of dollars in payouts from big brands, often by increasing the company’s debt. If there is little or no corporate reinvestment in a brand’s future, franchisees must speak up. This is best managed in a skilled, coordinated and assertive way through an independent franchisee association. Downtime can and does occur when inertia sets in and money flow in the company stays too long. Franchisees must proceed to strengthen their position through the association to ensure collective reinvestment in the future.

Smaller franchises

Please note that in smaller franchise acquisitions debt is often not used at all. As PE has expanded into franchising, there are fewer unrelated brands available for purchase. The result divides the players and their approach. For larger deals, recently lower rates of interest have concurrently fueled price inflation and encouraged the use of debt, including securitized debt.

However, smaller deals tend to be all-cash transactions, particularly for acquisitions integrated across multi-brand platforms. The platform’s larger money flow can at all times be securitized later, once scale is achieved. PE sponsors of emerging brands are due to this fact focused on accelerating growth, adding supporting infrastructure, building common platform resources, and ultimately, multiple arbitrage opportunities to help increase the overall valuation of the company. The use of debt is not a primary strategy to create value for the sponsor in such transactions. In theory, this closely aligns the interests of franchisees and sponsors inside emerging brands and platforms.

Potential franchisees should assess where the brand is in the spectrum of activities and to what extent the use of debt is a key element of the value creation strategy for the sponsor itself. As long as appropriate investments are made in the way forward for the company, there is nothing improper with using reasonable debt in an efficient capital structure. But when parent company distributions significantly outweigh recent investments in the company in a rapidly changing market, warning signs should be raised.