Multi-Unit Franchisee Magazine Issue II, 2014 | Page 76
ExitStrategies
BY DEAN ZUCCARELLO
Will Valuations Fall?
Guidance likely to curtail bank lending
I
n March 2013, U.S. banking regulators issued new guidance designed to
curb increasingly aggressive lending
by both banks and finance companies.
The new guidance is intended to provide
a “safer” financial landscape and reduce
the risk of a financial crisis like the one
that occurred in 2008.
Background. Regulators have been
under fire from Congress and the current
administration for failing to address what
is believed to be overly aggressive lending
preceding the financial crisis. Historically,
the Fed could use its open market policy
to raise interest rates as a mechanism to
manage lending risk. Theoretically, weaker
credits and riskier transactions would be
unable to support the higher interest costs,
and thereby reduced lending risk. Today,
with limited ability to raise interest rates
in the current fragile economic recovery,
the Fed has focused on influencing leverage as a way of managing risk. Financial
system stability is the intended benefit,
as high-risk lending is slowed or stopped,
thereby avoiding (or at least postponing)
another financial crisis.
Guidelines. Banks, whether acting as
lead arrangers or syndication partners,
are being required to categorize loans
on their books to determine which loans
will b e affected. Loans that meet certain
criteria will be deemed “criticized loans”
and will carry a hefty risk insurance premium. This will drive down margins for
lenders and force them to increase rates.
The criteria for “criticized loans” include,
among other things:
1) excessive leverage, defined as an
EBITDA multiple over a certain level
(6x is being discussed);
2) inability to fully amortize all senior
debt or half of total debt (including real
estate, presumably) within 5 to 7 years
out of cash flow; and
3) lack of meaningful covenants to
protect lenders in distressed situations
(“covenant lite” loans).
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MULTI-UNIT FRANCHISEE IS S UE II, 2014
At this time, the specific details behind
the criteria are not exactly clear. For example, if a loan meets only one criterion, is
it “criticized”? Or does it have to meet all
three? How do the regulators specifically
define EBITDA? Are any adjustments to
the EBITDA calculation allowed? How
many “criticized” loans might a bank be
allowed to carry? Will one criterion carry
more weight than another? How will offbalance-sheet obligations be treated? Is
there a size limit that subjects a loan to
the test?
We believe that a meaningful percentage of loans in today’s franchise lending
marketplace would qualify to earn the
“criticized loan” status.
Impact. How will these new regulations affect the future for a business
desiring to expand through acquisitions
and organic growth, as well as its ability
to finance such transactions? While it is
impossible to predict exactly how this will
play out, it is apparent that the lending
complex is likely to pull back on leverage
as a result of the regulations. And lower
leverage puts a damper on valuations,
both today and in the future.
A basic M&A valuation axiom is “less
debt availability = less leverage for deals
= lower transaction prices.” It may take
some time, but the impact will appear.
And while this may appear to be counterintuitive at first, it stands to reason
that a seller’s decreased future price expectations can bring valuation closer to
a buyer’s present price expectations. This
would likely lead to increased deal activity
in the near future as sellers realize they
are at or near peak valuation.
Again, what this translates into for a
business owner is that banks will be able
to lend less money per transaction than
previously. This pullback will likely have
a somewhat negative effect on franchise
business valuations going forward.
Market actions. Private equity insiders
cite the new regulations as a huge obstacle
to overcome in terms of transactions currently in the pipeline that require financing, as lenders hesitate to follow through
with commitments as predictably as they
had in years past. Regulators have publicly
stated that curbing private equity risk is
an intended consequence of their actions.
On the other hand, private equity may be
in a position to fill some of the void left by
the banks, simply by becoming new lenders to select borrowers in need of debt.
Hedge funds and non-regulated lenders
are already filling this gap, and we expect
them to get more aggressive as they can
offer speed and flexibility in exchange for
higher rates and fees.
Banking insiders say they are very
uncomfortable with the uncertainty surrounding the new, stricter requirements,
and this is having a chilling effect on new
leveraged lending opportunities.
As a result of the regulations, we expect
that loan costs will rise. How much they
will rise is yet to be determined. There
will also be less capacity for high leverage
as banks limit the number of “criticized”
loans they make. In addition, banks will be
forced to require higher fees and higher
rates to compensate for the risk of running afoul of the regulatory constraints
and drawing attention to the institution
itself. Any loan has to provide the lender
a reasonable return, including compensation for the risk of increased scrutiny.
We expect increased lending rates to
put downward pressure on valuations.
We further expect that the specter of
decreasing values could result in a flood
of M&A activity in an effort to lock in to
today’s valuations.
Dean Zuccarello, CEO
and founder of The Cypress
Group, has more than 30
years of financial and transactional experience in mergers, acquisitions, divestitures,
strategic planning, and financing in the restaurant industry. The
Cypress Group is a privately owned investment bank and advisory services firm serving the multi-unit and franchise business
for 23 years. Contact him at 303-680-4141
or [email protected].