Season 5 Episode 1: The 2023 State of Franchise M&A

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02.01.2023

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Rick Ormbsy:

Welcome to The Restaurant Boiler Room, Season five, Episode one. I'm your host, Rick Ormsby, managing director at Unbridled Capital. Today in the Boiler Room, along with some colleagues from Unbridled, I'll be delivering a recording of a recent webinar entitled, The 2023 State of Franchise M&A. Things are changing rapidly in the M&A world right now and we tackle several issues, including considerations when doing a deal in 2023. Commentary on current supply and demand for buying and selling. Lending cap rates and EBITDA multiples. Thoughts on inflation, sales forecasting and timing of a potential sale, and examples of real time issues affecting current M&A transactions. The Restaurant Boiler Room is a one-stop shop for multimillion dollar merger and acquisition activity and financial complexities affecting the franchise restaurant industry. We talk money, deals, valuations, and risk. Delivered to the front door of franchisees, private equity firms, family offices, large investors, and franchisors on a monthly basis. Feel free to find our content at Unbridled Capital's website at www.unbridledcapital.com. Now, let's enter the boiler room.

Welcome everybody, and I think I would say we're really thankful for you all being here. It's going to be an interesting discussion, and for those of you who will listen to this on our podcast, which is The Restaurant Boiler Room, it's a big shout-out to you guys. The podcast continues to grow and we're thankful for that. This presentation here, this webinar will be available on our website at unbridledcapital.com and we'll also send out a link to the webinar afterwards when it's all edited and taped and whatever. You can catch it or forward it and watch it again if you can't stay for the whole time. But we're thankful that you're here and at the beginning of each year we want to get together and just talk about what we think will happen in 2023 in the M&A market. It's been back in the good old days, you would think, I was just talking to franchisees this morning, it was like back in the good old days things would go up or down by one or two or 3% in our industry each year, right?

I mean, kind of small micro movements and actually people who would invest in this business and get into this space, did it because it was a stable way to invest and a stable way to earn a living. And yet in the last couple of years it seems like, I mean, goodness, it seems like every week is a new crazy change that we've never really experienced before. I think if anything, at the beginning of 2023, I would just say that here we are, we need to keep an eye on ever-changing M&A market because it's shifting and changing a lot more than it used to. Here we are with Derek Ball, who many of you know, on our Unbridled team and then Peter Fisher as well. And so both of those guys, Peter for a little introduction with all those, you got so many degrees behind you there, buddy.

He used to work for Little Foods, which is a Taco Bell franchisee in Mississippi. So he comes to us with a background as a CPA and also an MBA, but as an operator of a Taco Bell organization, so his insights will be well received. I'm going to ask some questions along the way, so I would please invite you guys to raise your hand and you can add a private comment or ask a private question. One of them I'm going to say, if you're an operator right now, what are your sales like right now? How are your comp sales looking in January of 2023 versus last year? We've had two conversations and I've had two conversations the last 30 minutes. One franchisee and a chicken-based brand is down a little bit and another in a non-chicken QSR brand is up in Q1 so far versus last year.

If you have any insight, shoot it over, we won't name you, We're not even going to name your brand, but as we go through this webinar, we'd like it to be iterative so you guys can add some comments. With that being said, let's go ahead and fire away. The first question that we want to address today, and we've got basically nine questions we're going to go through. First one is, a commentary on the current supply and demand for buying and selling restaurants in 2023. So that's my question for you guys. Maybe Derek, you can start off? What's the state of the market looking like from a supply and demand standpoint? I mean, relative to the last few years, what are you seeing?

Derek Ball:

I mean, I get this question daily from buyers. All buyers are calling us asking when prices are going to start dropping. And logic would tell you that prices should be dropping with just the uncertainty in the market. Inflation, commodity issues, lenders are getting a little scared and raising their rates and dropping their leverage. Everybody is tightening up. Your cash flow might not be as pretty as it was a couple years ago. So, all logic would tell you, and I tell this to everybody, is that prices and multiples should be dropping. We haven't seen it happen yet and I think it's for one reason and one reason only, it's because there's not really any deals out there. You throw a decent deal out there that's not in distress, not in bankruptcy, and you're going to get double the eyeballs as you had in previous years.

I hear around, we don't have a ton out there, we have a couple, I don't believe our competitors have a lot of big deals out there. You hear more and more about distressed and bankruptcies and lenders are going to shy away from a lot of those deals too. So the current supply and demand, I would say there's a ton of demand. You still have a ton of buyers out there. You still have people that want to put money to work. You still have the buyers that feel good about the long term of the restaurant business, especially if it's a good business they're buying, not a turnaround situation, but there's nothing to buy.

We're seeing double the amount of people looking at individual deals than what we had before. I think, Rick, you said on a recent webinar, in 2021, we did what, 37 deals in 2022 we ended up doing 13 or 14 and I think this year we're hoping that re balances a little bit. We have a lot of deals under engagement that are floating over from 2022 they're hoping to close first half of this year, but we're still not seeing a bunch of incoming calls. We're getting some, but you're not going to just see us unleashing six deals in the next month. I don't expect that to happen. I expect the supply to still remain pretty low for the time being, but there are still plenty of buyers out there. Say that's a overall kind of answer.

Rick Ormbsy:

Yeah, I think that's right. To give a little more clarity to your comment too, number one, I think you mentioned the stats. I think right now we've got 14 or 15 active assignments. We've had a couple, like two new assignments come on board in the last what, couple of weeks. And generally speaking in terms of pacing and sequencing across a year, January is typically slow. Usually at the end of January until the middle of April is when you typically do get 50 to 70% of your new assignments in a year happen in that window. So we're not there yet. It's difficult to say, but I mean I'm doing one of these numbers and trying to take the temperature and I kind of feel like the supply of new deals is going to be lower than normal, maybe more than it was in 2022, but certainly less than what it would be over a five to seven-year period.

The comment that you're making about one new business we put on the market and it's going to be a nice tier one A plus type of asset we have on the market. I mean, we have over 125 groups wanting to take a look at it and probably expecting 10 plus offers on the business. And that's clearly a result of the supply demand balance being somewhat out of whack. We had a question that came in that I think would be interesting. And it's like what firms are actively buying or have signaled that they're buyers in 2023? That's an interesting question that I think, I don't know that I've heard anyone say that they're not a buyer really. I mean, there may be fewer buyers because they don't have ... They may be slightly more leveraged than they were before because they're down and they don't have the borrowing capacity.

But keep in mind, a lot of buyers are pretty flush with cash from the ERC credits, ERTC credits that they're receiving and are bringing into their companies and they have a lot of cash on the balance sheet, significant cash on the balance sheet if they've not done acquisitions at high multiples in the last couple of years. So, it's my personal view looking at this that we may be entering some sort of a place where you see more strategic buyers jumping into the mix where they haven't in prior years as much. Because they were getting out-priced and outpaced by the family office and private equity groups that were paying based on high EBITDA multiples were able to borrow 85 to 90% of the money that they were getting. And then the cap rates were so incredibly low or favorable that they were able to produce these huge acquisition prices that strategic buyers just weren't willing to pay.

But then when you flip into a downturn, usually the opposite starts to happen. The guy next door may have a better reason to see through patchy three or six months of EBITDA, right? Because they've been there for 30 years, they've operated in these small towns and they know the trumpet player on the high school band, you know what I mean? And they could see beyond just what's on the page at this current time. That's probably something that will may change the dynamic slightly in 2023, as will I know we'll see the kind of the vulture buyers coming in for some of the distress deal to provide liquidity where the banks just won't provide it.

Derek Ball:

Yeah, I think it's not just who is the buyer, who's not the buyer, it's the right deal. And almost everybody that calls us, even the ones that are calling me asking when's the winner price is going to start coming down, they're still buyers, they're just not going to stretch like they may be dead in 2021. And then you've got the long term, I want to say mom and pop, not mom and pop, but the long-term owner operator franchisees that stayed far away from the 2021 prices that are now looking to come. Now the prices are getting a little bit back to normal, I would say, maybe still over five year averages outside of 2021, but getting back to normal and they're looking to put their hat back in the ring where they would've stepped aside a couple years ago. I don't think it's who is the buyer, I think it's most of the buyers are, they just change their outlook. And some are going to be a little more aggressive than others right now and it's buyer-specific, but I think what Rick said was right.

Peter Fisher:

Yeah, I think the mid-size operators have had a chance to really hone in on their current operations, really build their balance sheet and put them in proposition to purchase to make an acquisition this year.

Rick Ormbsy:

And as I look, another question that comes through, and this is a good one, how are we driving valuations right now? So it's interesting, Derek and I just got off a call with the franchisee who said I threw out 2022 and I threw out 2021 and 2020, what he said, and I've looked at what the business was doing in '17, '18 to '19 to get a feel for what I think the potential for the business is. That's a strategic buyer that makes that comment, not a financial buyer. I think it depends on the type of buyer that you're looking to attract in this market. If you're looking at a financial buyer for your business and you're looking for that type of approach, you're going to be looking at a trailing 12-month financial statement. And we might be able to put some say like, okay, when have you implemented pricing initiatives and have they rolled through the P&L and are they showing results and can we look at them on a forward-looking basis a little bit?

What's going to happen to commodities? Are commodities set to drop and are they dropping right now, and can we maybe make a qualitative or maybe even quantitative adjustment or at least discussion with the buyers about the future of food cost? But largely, I think you see that dichotomy between maybe a strategic buyer and a financial buyer, but still in many cases we're looking at pricing things off of a trailing 12-month financial statement. And a lot of, I was talking with a franchisee of 70 units or so maybe last week, and he said that he feels like 2022 is obviously the worst he's had. They were down 40% in EBITDA in 2022, a combination of sales and mostly profit dropped because of labor and food cost. But he says, "Our projections are that by the end of 2023 we're probably going to be, or even at in the third quarter of 2023, we should be probably somewhere between where we were in '21 and '22."

Which to him seemed like a reasonable place to be discussing the transaction, realizing that we're probably not going to get back to that 2021 perfect storm again. Maybe in 20 years we will, but not certainly in one or two or three or five years. All right, so that's the first question, rock and roll. Second one, what are the EBITDA multiples in the cap rates? What are they and what are they looking like? That's a juicy question that everyone wants to know the answer to, so what do you think?

Peter Fisher:

I think cap rates have definitely taken a hit. This time last year in Q1 with the re-market we're anywhere from five and a half to six and a quarter, maybe six and a half, but here we are year later and we're shooting around 6, 7, 5, maybe seven and a half, so definitely come up a lot on cap rates, maybe 150 basis points or so. But the 1031 market exchange, it's probably still seen a little bit of a bump, but not quite like the re-market. Still looking at sales and looking heavily at coverage ratios and that sort of thing, but the rate market's definitely taken to increase a lot more than the 1031.

Derek Ball:

Yeah, I was talking to a real estate broker, I think it was last week and the 1031 market was so crazy and up until about a year ago and I was just kind of talking to them, I was like, "Well, who are the buyers in the 1031 market?" Before it was just some random doctor, dentist looking to put a million bucks to work and they didn't really care about anything, they just did it. They had the money, they had the money to spend and they wanted to defer the taxes and let's go ahead and buy it, whatever cap rate. Apparently even on the 1031 market, there's a little bit more analyzing of what are the sales of the store, what's the coverage ratio, what's the price per square foot, all this stuff that has always been important but maybe was a little more overlooked when everybody had so much money to throw around a year ago or two years ago.

So, that is a change. And talking with another real estate broker recently, cap rates actually got better last month by about 15 basis points just per their numbers over where they had been. Their expectation is those start to go back up though and get worse. Those interest rates continue to climb. But you know what Peter said is spot on. I mean, if you're selling to a REIT, my understanding is you won't get anything without a seven on as the first number. Might be a seven, might be a seven and a quarter, depends on the quality of the asset. But just like banks, which we'll get into in a little bit, the real estate buyers are looking much more, are scrutinizing the deal a lot more than they would have been two years ago.

Rick Ormbsy:

Given you some data around the 1031 market. I mean, this is broad data, even though I'm going to give specific numbers. The asking prices, the average asking price for retail piece of real estate right now is around 5.75 cap roughly. That's asking price, I mean it'll close at that, likely closes on average higher than that, maybe around six, but it's trending worse, no doubt about it. Within that there are obviously huge differences. A piece of Taco Bell real estate in Florida is going to sell for a way different price than a piece of Hardee's real estate in Omaha, Nebraska, right? There's just going to be a delta between those. So, we're only talking about averages here and then you go down to office space is probably the one that's probably been burned the most and they're probably the average asking price is over seven cap on the 1031 market there now and probably trending worse too.

Couple of things that I've just been reading. It looks like that there have been a drop, there has been a drop in buyers in the 1031 market in the last couple of months. This is just a couple people's comments. I mean, maybe it's towards the end of the year, maybe it's not. Maybe it'll pick back up, but buyers drop out of the marketplace when the prices are high and they can't borrow money at competitive terms to make their returns. The 1031 market has been driven for a long time by cash buyers, a lot of them from California who are selling things and trying to avoid paying capital gains taxes, so that for the small size deals has kept those cap rates steadier than they otherwise would be. But as you get to the larger end, you're starting to see, I think cap rates change.

Wouldn't be a surprise then, you're right, Peter, 150 basis points, maybe a 100 to 150 basis points change in the reap market and maybe half of that, let's just say is happening so far in the 1031 market. So, what does that mean? It means that people who are either operating businesses or buying businesses or selling businesses, for a seller, many times sellers, we're now going through the process of talking about what maybe keeping their real estate for a time and then selling it when it's more liquid at a better price, or maybe finding a different method to finance the sale of the real estate. So there's a lot of, given that the banks have gotten much tighter on their lending policies and practices in the last six months or so. These are things that just require a little bit more iteration and discussion. Any further comments? Let's go to EBITDA multiple. That's someplace that we spend a lot of time talking about. What's going on with EBITDA multiples? I mean, Derek, you started the conversation saying we haven't seen a change in prices.

Derek Ball:

I'd say the answer to that is we haven't seen a big change because we haven't seen a lot of deals. I mean, that's the short and sweet answer is we don't have 20 comps over the last quarter to go on like we did in '21 and even 2020 we did I think more deals than we did in 2022. It's just, there haven't been a ton of comps out there to change where multiples would be. Like I said at the start of the call, logic tells you multiples should be coming down. The deals that we have had recently have not proven that out. So that might, once you start seeing more deals hit the market, that supply and demand changes a little bit. You might see, and I would expect to probably see multiples come down a little bit.

Now, I don't think a deal trading at a six is suddenly going to be four and a half, not in our current state. I mean, if lender's completely dry up that that might change, but maybe that six turns into a five and a half I'd expect a half a turn drop generally speaking, potentially more in certain brands. And keep in mind the deal itself becomes extremely important if it's a turnaround deal, or a brand that's struggling, that's going to drop more, that might go from a six to a four and a half to a five. But if it's a good tier one brand and a solid business in and of itself, I think you're going to see that kind of rise to the top a little more. And you're not going to see the downshift in the multiple on that particular deal quite as much as you would if you had a deal that was struggling.

Rick Ormbsy:

Yeah, I think we saw the restaurant monitor come out this month with a list of what is a tier one brand? And they listed, to my knowledge here, I'm working off memory here. Number one was Taco Bell, I think Dunkin was maybe two or three. He had Popeye's up there towards the top. He had Wingstop up there towards the top. The point I'm making here is that the brands that are at the top of the tier one category, which are the ones that we typically do the most work in, are the ones that typically have the most interest, have had the best performance during this time and therefore have the most buyers who will pay the most money. So we don't necessarily, we're not working as much in the distressed arena, in the bankruptcy arena, which in several brands is becoming a really hot area at the moment.

But if we were planting ourselves firmly in that space, we could probably tell you that in many cases the multiples might be moving down from a five and a half to six down to a three and a half to four. You know what I mean? If it's a bankrupt deal with high leases, crappy areas of the country to operate in, pardon my French. But our perspective is generally coming from the top of the tier one range or maybe slightly in the middle of the tier one range. But deals that are good deals, really good deals. I think if we strip that out of the 15 assignments we're doing, and of course like Derek says, we only have a couple of new assignment to draw data from. I would say that it would be likely that the average deal is trading for a half to three quarters of EBITDA less than it was a year ago.

Derek Ball:

I mean, that in of itself might be a five to 10 to 12% change in pricing, but the bigger number is the EBITDA itself. Because when you get to a price, you've got to multiply, so many people, the majority of people buy on assuming they're going to get X amount of debt and at a six multiple, let's say you need to get 30% equity and 70% debt. Well, if the bank suddenly says, "We're only going to finance 50/50 debt to equity," usually buyers are not going to be willing to make up the difference in equity. What that ends up doing, maybe they'll put a little more in, maybe they won't, and what that'll do is that'll drop that multiple from a six to a five. Naturally, I mean, that's a very easy way of saying how it works. If the lenders start drying up and they don't want a loan on the business, if you can't go get debt on a particular business, that six multiple might be a four. The buyers are not going to make up the entirety of the delta with equity, they're just simply not.

So the stronger the business, the more aggressive a bank is willing to be on it, the steadier the multiple will likely be. But even that, I mean I think we get into this somewhere else. I mean, I'll just tell you even Taco Bell's, Taco Bell's top dog, it just is there. There's hardly any arguing. Two years ago we did REFI for a gentleman, it was a fixed rate in the low twos and he was like maybe two and a half percent. And if you were to go do that same thing right now and not fix it, it just floated. It was so for 250, which is pushing 7% interest. I mean, if you're a buyer, obviously that ROI changes significantly when you're going from a 2.5, 3% interest rate to a seven. There's no arguing that either. It's a massive change.

So, hopefully it's not a 20-year loan by any means. Hopefully rates get a little better in a couple years and you can re-fi it and everything, but it's a lot of interest to pay for the first couple years at least. So it's affecting buyers for sure. That's why I get calls literally every day from buyers asking me, "When are prices going to start coming down?" And just due to the fact that there aren't a lot of deals out there, I can't say yesterday, I can't say tomorrow, I don't know. Because there are people that still have money that they need to put to work in the buyer pool and they're maybe willing to stretch another 10% than they otherwise want to, because they don't know when the next deal's going to be.

Rick Ormbsy:

And they're sitting on a lot of money. Again, going back to these ERC, ERTC credits, a lot of the mid-size franchisees are sitting with millions of dollars on the balance sheets, and nowhere to put the money. I mean, I guess one thing that's been concerning to me is I've been yapping about it, about how last year at this time we were in the middle towards the end of Omicron and I thought sales would be in a little bit of a better position than they are now generally across the industry. And if anyone listening here wants to comment about how their sales are doing. I mean, would have just in a black box said, "I figure sales would be up 10% right now given where we were in January of last year." But it doesn't feel that way and it actually feels like we're struggling coming out of the gate a little bit from a sales perspective in many brands.

And that's slightly surprising to me. I know, and I know we have probably a heavier bent in the southeast, particularly in the business we do and in the Midwest, and those areas probably didn't have as much of a effect as maybe some of the blue states in terms of that. But I'm kind of a little bit surprised. There was a question that popped up here. Let's talk about it. How are CapEx and deferred maintenance impacting valuations today versus a year ago? What do you think?

Derek Ball:

I don't know if I can answer it perfectly, but I'm not sure, we're not looking at it any differently. In every deal a buyer's going to do a walkthrough of the restaurant, so they expect it to be in good working order up to franchise or standards, whatever language you want to end up inserting in the APA. And if it's not, they're going to ask you to fix it as the seller. They're going to ask for a credit. We go through that negotiation on 98% of our transactions. If you've let your stores fall apart more than you should have, you can expect to get dinged during the deal. If you put a lot of money back in your stores and buyer does a walkthrough and is really impressed, you can expect that to be okay. If you've been struggling on EBITDA and you're trying to cut costs, maybe the question is stemming from have you been deferring maintenance a little more than you otherwise would have in prior years?

But again, I don't think I look at it any differently than I normally do. It just might be a little higher of a credit if you've let your stores, I don't want to say fall apart, but if you've let things slide a little more than you would've otherwise done. Just trying to make bank payments and keep EBITDA strong and keep your covenants there. I'm not sure I look at any different obviously, and every brand has remodel either a midterm or a final franchise agreement, expiration remodel due, and we look at those the same way too. Usually we look at a few years and look at the expected cost and kind of cut it in half, half on the buyer, half on the seller type of thing. That's how we often internally value their exceptions to that. I don't look at that any differently today than I would've a few years ago either.

Rick Ormbsy:

New development is clearly an issue. If you're inheriting development obligations, buyers are, I mean, rightfully so, heck, it's hard to find building materials. It's hard to get things built today. I mean, prices have gone up to where now the cost of capital has changed and the return on investments dropped quite a bit. I mean, heck, to build any given restaurant probably costs 25% more now than it did just two years ago. I mean, that's a random number, but it could be right. And it makes the case that revisiting some of these development obligations and the timing of them has become a big part of it. And there are a couple of brands that involve burgers that I won't mention the name that have this cliff where almost all of the system has to be remodeled by X date a couple years in the future.

And so that becomes a material consideration and we look at valuing and buying and selling these assets. If you have this hardcore, all the system has to be developed, has to be remodeled by X date, and we're sitting in the middle of a recession where it's hard to borrow money and the timing on labor and resources and product costs are really high. That's a material consideration that has to be looked at. And typically what we tell our clients is, I mean, you want to get in front of that window by two or three years. I mean, you don't want to be trying to sell something eight months before the obligations are due. Because then all you got is everybody and their mother's going to say, "Shoot, I can't do these obligations that you're trying to put on me and then I'm going to go to corporate and then it's going to be a negotiation, which is going to inevitably result in a lower price for me."

So, you got to be careful about how you think about the timing and pacing and sequencing. In terms of actual CapEx itself, most of the sophisticated buyers are going to look at benchmarks and they're going to look at an R&M expense. So they're going to say, I expect a typical R&M to be somewhere between 1.4 and 1.7% of sales on a trailing 12 month basis over the past 20 years. I mean, whatever the number is, but it's probably somewhere in that range, maybe as high as 2% depending on the brand and the AUVs of the deal. Or maybe it's as low as 1.25 to 1.3%, but if you start lagging down into the 0.75 or 1.0 range because you're trying to not do any remodeling to bump your EBITDA up, most of the time people are going to recognize it and say, "I'm going to lower my proforma EBITDA when making an offer." Because you've basically squeeze the turnip a little bit too hard here, and I can't do that when I run my own business. There you go.

Derek Ball:

Squeeze the turnip. Is that an actual phrase?

Rick Ormbsy:

That ain't a phrase. That ain't a phrase. What am I going to squeeze something out of, squeeze the life out of something? You saying an orange, I mean, an apple, can't squeeze out-

Derek Ball:

I think you're just referring to squeezing the juice out of it.

Rick Ormbsy:

There you go, squeezing the juice out. I just planted a lemon tree in my backyard and I'm hoping I could squeeze some lemon out of that sometime later this year. Let's talk about the lending market, which I think is really cool topic. And there's a couple of comments coming in here. I'm going to read these real quick. One of them is, are you seeing more creative deals with seller financing and earn outs lets address that? The answer is yes, yes. Seller financing was unheard of in the last five years. Now I would say, guys, we have 15 deals going, most deals are incurring, you guys didn't like me to say re-trading, so the word is price adjustments. Most deals are having some sort of price adjustment discussion if EBITDA is dropping because of stricter lending standards and lower EBITDA. This is indeed reopening, and we're going to talk about this a little bit more, but these deals are taking probably a time and a half as long as they normally do.

It used to be that even in the last five years we probably had an average deal was closing right at six months from the time we signed the customer up at the time the deal closed. I would say right now, guys, tell me if I'm wrong, that we're probably in the nine-month range to get a deal closed, at least in 2022. Franchisors are [inaudible 00:29:10]-

Derek Ball:

What's pushing it down now is just the uncertainty of last year, I think just created natural delays, just everything dragged a little bit longer. There were so many uncertainties in the market, buyers were hesitant and things just dragged and they just went a little bit slower. And we are an unbridled trying to counteract that right now by pushing things through a little bit quicker. That's our, I wouldn't call it our New Year's resolution. But that's kind of our initiative for 2023 is to be on all parties a little bit harder to meet timelines. But in terms of the very specific question, are you seeing more creative deals put together? Not yet. And the answer to that comes down to what I've already said a couple times. There haven't been a lot of deals out there. I think sellers understand the difficulty of the market, the difficulty of where the lenders are, cap rates, everything.

I think sellers get that. It might be part of the reason they're looking to sell it all. And just retire and go into the sunset. But I think you will see more sellers being willing to do that type of thing, but ultimately it comes down to what the offers they have. They're not going to take a complicated offer over a similar priced clean offer, getting paid at closing. So it comes down to the deal itself in the other offers that we're able to generate for the seller. If that's the best offer, then I think you'll see sellers generally willing to do it. But recently and just really almost forever, as long as I've been in the business that those types of things haven't been needed just because it's been a flush M&A market and QSR brands. But I think you'll see more of it. I do think you'll see more of it in 23.

Rick Ormbsy:

Appreciate the comment. The actual way to say it is squeezing blood from a turnip. Thank you. Thank you. Squeezing blood from a turnip. What was I trying to say? Squeezing juice from a turnip. Oh man, I think I'm getting old. All right, so another question that's an interesting one has to do with, is the franchise or exerting more influence over, are they be becoming more influential regarding who is selected as the ultimate buyer? Man, that's a good question and you got to be judicious in how we answer that question, but the answer to the question is hell, yes, they are. They absolutely are. And this isn't just one brand. I mean, I think we've got deals going on at six different brands at this very moment, and I would say it's a common trend throughout the industry. You have some brands, for example, that aren't performing well, or maybe their sister brand isn't performing well, therefore now more leery about new people coming into their system and much more scrutinizing on allowing new people into their system.

You have other folks who, I mean, there's just a variety. Not to get too specific, there's a variety of reasons why the franchisor in many cases is becoming more influential in the process. And of course, I mean we would probably use a time of relative pain, wouldn't we, if we were a franchisor to get more involved, right? Because you want to protect your brand. And so I think that's a pretty common thing that we're seeing. What do you think about buyers and FAST Act? Anyone want to answer that FAST Act in California? The idea that minimum wage could be going up into the low 20s and set by a team of, I guess it's nine people that are going to set the policy for wages and conditions in the restaurants? What do you think?

Derek Ball:

Everybody seems to have an opinion on it that that's associated with California. I spoke with someone last week who is certain it's going to happen and they don't know any way around it. And then I talked with someone an hour later who says there's no way in heck that it'll happen. I don't have a really strong opinion on whether it will actually happen or not. I can't answer the fact that it is impacting buyer interest in California. Until it gets answered buyers are going to assume that it is going to get passed and sellers want to assume that it won't get passed. And what that's doing is creating a pretty big imbalance with expectations.

Rick Ormbsy:

I think that's right. I think that's right.

Derek Ball:

I don't know if it will pass or not, but it is affecting the deals and it's hard to get a deal done right now in California, simply because when you have a seller wanting X multiple and a buyer saying, "Well, I'm only going to pay you this in case the FAST Act goes through," it's hard to come to a deal. That's been a recent experience.

Rick Ormbsy:

If you were just taking a business that had, I mean, just to contextualize this, not this fast on the numbers, but if you had a business that had 1,000,005 80 V and 20% pre-G&A [inaudible 00:33:34] our margins and had a $13 or $14, maybe just call it $15 minimum wage and you roll through a $22 minimum wage and you don't get any pricing increases, just what impact does that have? Your post-G&A EBITDA margin basically goes from nine to 10% to one to 2%. So you lose 80% of your margin. That would take a business that would sell for let's say a 100 million and it would take it down to 10 to 20 million. That's what we're talking about here.

Derek Ball:

Obviously that's-

Rick Ormbsy:

Holy crap.

Derek Ball:

You can price, you can do things to counteract it, but to counteract it a 100%, probably not in the short term, it'll take years to be able to make up for that. So, Rick is not saying a 100 million business is now 10 to 20.

Rick Ormbsy:

No, I'm not saying-

Derek Ball:

You just run an easy math. That's what it does, unless you make the proper adjustments to get the value back. And that's where you would see too much disconnect between buyer and seller.

Peter Fisher:

That might take a year to adjust for it.

Rick Ormbsy:

Let's talk about lending a little bit. I've got my little yellow notepad here and I took some notes here just today talking to somebody. This is interesting. So banks, this lender, well-respected lender told me, he said that we are going to be hitting a credit crunch. And he says it's because banks have a lot of balance sheet pressure because their deposits have dropped so much. And because their deposits have dropped so much, their loan to deposit ratios have changed a ton, and because of that, it is going to reduce the amount that they're going to be able to win. The phenomenon is like, okay, I don't know about you guys. Are you guys still parking your personal money in a bank account at U.S. Bank or whatever it might be at 0% interest or have you sought to find a money market for U.S. Treasury that's now paying three to 4% interest?

I mean, I've certainly done latter, I've pulled all my money out of traditional banks because I don't want to park 0% interest, and that phenomenon is going on around the world. And of course, smart money has already done that. Big dollars have already left all the banks. What you have is a bank is lending a portion of the money that it has in the darn vault out to customers. It's simple. And if everyone's yanking their money out of these banks because they're not offering any interest on the money, then they have less money to be able to lend out and it's going to cause a huge credit crunch. This is not anything that we didn't know. Everyone from the Federal Reserve down knew that this was going to be a result of this process that it was going to lock down. That's kind of what's happening.

And that projection is it is actually probably going to worsen throughout the year in my opinion, and that's going to make it harder, progressively harder and harder to borrow money throughout the year. That's what we're running against in a broad scope. Now, we still have a lot of liquidity in the market. We still have in the restaurant franchise M&A, we still got 20 lenders out there. Maybe there were 30, now there's really 20, there's less, but there's still plenty. And we don't have any darn deals, except the distress ones that you're hearing about.

There is going to be, in this supply demand situation there is going to be liquidity for a good deal, but if we do reach a point, and this is actually a pitch to people who might be considering selling their company at some point. We do reach a point where there's more supply on the market with a tightening credit situation because of these depository problems we have, then you could see yourself a situation where there's not enough liquidity and prices drop pretty fast in a hurry. Almost like a flash flood where you all of a sudden it rains three inches and then the whole street in Las Vegas is washing five feet tall with water. So, that's just something to keep in mind. Any other comments? Yeah, I've got a couple more, actually. Do you guys have anything to say on lending? I got a couple other comments here.

Peter Fisher:

Well, that is just that you make a good point. Not as much money to lend, which makes them focus on quality rather than quality. So the riskier loans, it's going to be left hanging for dry and it's just going to be hard to find lending for the business that aren't doing as well as the other ones.

Rick Ormbsy:

One guy's saying, "Loan to deposit is important, but we're still in pretty good shape and willing to win." That's good. Here's another lender. We look at the deal on a consolidated basis. In those instances it all comes down to cash flow coverage. I'm not trying to be a doomsday guy, those of you who know me know I'm pretty optimistic, but I think that's a concern that we have to watch out for. It is true that some of the risky loans that are out there and some of the kind of more hard money lenders are approaching double digits on their interest rates now, right? It is not impossible to see that we could be at a 10% interest rate in some deals, in some brands later this year. So like Derek said earlier, and Peter said too, that's something that has to be factored in.

Let's see, rates have risen. Because rates have risen there's some unrealized losses on the balance sheet. Fixed charge coverage ratios. I don't have an absolute number for you, but they've changed maybe up to 10 to 15 basis points is what one commentary is. And they're becoming more in play because interest expense is eating up the cushion, the lease adjusted leverage. I have to worry about EBITDA compression. I mean, what that does to the lease adjusted leverage calculation. And in terms of straight leverage, this one lender told me that that's not as pertinent to their business. But I know from some of the lender studies that we come out with every six months or so, that several of you who are restaurant lenders look at straight leverage when making loans. We've been yapping a lot, haven't we? Or maybe it's been me who's yapping. I'm always yapping.

Derek Ball:

Someone asked, just a real quick question. Someone asked how our franchisees viewing development agreements, any hesitancy to these increase? I would say generally it depends on the brand. Depends on the specifics. If you've got a very saturated brand and everything is going to be cannibalizing your existing business, yeah, I would say there's hesitancy generally speaking. But the bigger hesitancy, and I'm sure where you're kind of leading with this is building costs are 150% where they were three years ago. A lot of people are not wanting in my personal experience to commit to building a lot.

At the end of the day my opinion is, if franchisee views it as making sense and they're going to be able to make money and have a solid ROI, they'll build. That's generally the answer unless you're really struggling. But if the ROI turns almost to zero and you're putting 150% of the build costs in there and EBITDA is struggling, you don't know where it's going to be. And it might cannibalize 20% of a nearby store. If I'm a franchisee, I'm not doing that and I don't know if I would want to commit to a massive obligation, or I might be penalized by the franchise or if I don't do it. I think it is a big factor and certain brands are more aggressive obviously, than others. You got to pick your battles and pick a brand that you think is going to be reasonable with development asks.

Rick Ormbsy:

Some brands are getting very reasonable. Some brands have, I mean I can think of one, I won't mention them, but one brand in particular that's really changed, totally changed their view on how they think about development for the new franchisees. They used to be really, really firm and really maybe even unreasonable and now they've become very, very conciliatory. And some of that's because of the performance and the lack of relative lack of people wanting to come new into their brand and some of the struggle performances. But I think it's a spectrum, isn't it? The best brands are the ones that could command the most obligations and the hardest line on things and people will tow the line in most cases because they're the best brands, and they have the best returns, and they have the best products. And they're right. And then you have the brands over here.

Where you are stuck in, so it's an individual discussion. We can always talk with you privately about our experience and certain types of brands, but the brand that you want to be careful of is the one in the middle that's kind of falling off a little bit, but is still unreasonable in terms of their development obligations. The other deals that are over in here, you have some negotiating revenue. Now if they wanted you to develop a certain amount of stores, push back a little bit and say, "Well, I mean, I'm not willing to do that potentially." Now it's typically a good time to negotiate a little bit, right? If you're a strong, well-capitalized franchisee wanting to come into a brand that's had some performance issues recently. What about yesterday's buyers were family office and PD consolidators and who are today's buyers? Why don't you guys take a rip at that one? What do you think?

Peter Fisher:

Well, we discussed it already I feel like a little bit earlier, but I think buyers that feel confident the commodity issue is going to go away at some point. If they can see past how high commodities are right now, they'll see an opportunity to be in a place to reap those rewards if they're already have the business in place. I think also mid-size operators, we talked about that earlier. I think they kind on the silo for the past couple of years, but if they really looked at their current operations, got them in place, they've got a big balance sheet and looking to finally expand and they're ready to purchase again.

Rick Ormbsy:

Yeah, no doubt. Derek, you got anything to say?

Derek Ball:

Yeah, nothing that we haven't mostly said. When things are good, a lot of the institutional money buyers end up having the best offer. But when things aren't quite as good and you're looking a little bit more of a turnaround or as you see it from Unbridled, we don't put a bunch of proformas and things in our models, but as buyers, obviously you're always looking at proforma projections. Seeing what you can do. Generally speaking, it's the owner operator, strategic buyers that have been in the system for a while that in my opinion do more of that. So when things get a little tougher, they come out of the woodwork a little bit more. When things are really good, you are seeing the institutional buyers, it meets their ROI requirements and whatever they have to answer to a board.

You got a guy using his own money and he can do what he wants. Everybody looks at it, they want to make money. Nobody's just throwing good money after bad typically. But yeah, things just change a little bit when the market gets a little tough. Those old school franchisees look at things a little different then a lot of the new groups that are entering these systems.

Rick Ormbsy:

And then I said it once before, but obviously the bulge of funds, and I hate to use that word, but kind of the capital front funds who have a lot of cash, you want to make a quick deal and can control the capital structure and pay cash for the deal in bankruptcy or in distress. Those are going to be a component of today's types of buyers. So they're going to probably one evaluation that's 30 or 40% less, but in exchange for that, they'll provide the entire capital structure in 45 days. And so as we see some high profile bankruptcies and other transactions in the marketplace, that's a component of the system that will be a part of things in the next year or so. All right, why would you sell now, why would you sell a company now 2023, right now? Why would you do that?

Derek Ball:

Most of our clients, the M&A and franchise world are changing quite a bit. In 10 years it's going to be more institutional funds, trading deals back and forth. We talk about that at Unbridled just internally a lot. Obviously we have to plan our own company for the future. Groups of family office group, PE groups, friends and family groups, just generally institutional money. I mean, that is generally who was buying most of the businesses out there in the last five years. So, in 10 years, the old school owner operator franchisees will be in much lower volume. They're just not going to be there as much. Most of our clients, the answer of why you sell now, the reason that's irrelevant or relevant is most of our clients are second, sometimes third generation franchisees that are nearing retirement age. The reason they're selling is because they've been in the business 30 to 50 years and transparently it's not always as much fun the last three years as it was for them.

They love their people, they love their restaurants, and they want to be in their restaurants every day. But with where the world has turned in the last few years, it's caused some heart issues, some gray hair. I mean, people are just saying, "I been in it for a while. I'm at 65 years old and I need to sell it to the next generation of franchisees and I'm going to go enjoy the beach or the mountains and retire, play some golf, do something." I would say that is the primary reason people are looking to sell right now. And that's most of our clients that are just at retirement age. And they look at the next couple years as probably being difficult too. And if they thought it was going to get better tomorrow, their opinion might change.

But it's tough. It just is. It's tough to operate restaurants right now. If you're a 40-year-old guy and that's what you love and you want to do it for 20 more years, keep buying, because QSR's not going anywhere. But if you're at that age, it's just, "You know what, it's my time." And that's 90% of our clientele.

Rick Ormbsy:

The heart issue is really one that hits home to me. We've had a couple clients this past year who've had heart issues and I was at church on Sunday and pastor said, "I'm feeling if you've had heart problems in the last year as we're bowing our heads, close your eyes and raise your hand. I want to pray for you." And so with the congregation's not looking around to see who's had heart issues, but I could just feel that the pastor being blown away by the amount of people who had their hands raised. It's like it hadn't been all that easy, I guess is the point. Sometimes, and I'm this way in my life. I'm sure you guys are too, and people who are listening to this, difficult situations forced you to reevaluate what's important to this life, and you only live it once on this earth. So sometimes those emotional reasons become important considerations.

And another reason could be that people think that the future's going to be worse than the present. That could be a real reason why people might decide to sell now. Health, emotional reasons from the past couple of years of stress and strain. The future looks worse than the President [inaudible 00:47:14]-

Derek Ball:

Not just the 10-year future, but if someone's thinking about selling and they think the next two or three years are going to be just as tough, they don't want to wait three or four years or five years to sell that. It's not, I mean, QSR is not going anywhere. It's going to be strong for forever, in my personal opinion. And I think that's how most people feel. But it might be a couple more years at really difficult times. So these guys are just looking to get out now. The market is still there. They're still a strong market. You're not going to get as much as you would have a year and a half ago or even a year ago. But if you look at a long trend in history and where multiples and prices are, it's still a competitive market. If you're comparing your deal to 2021, then you're going to be very disappointed.

But if you compare it to a 20-year history and look back, it's looking darn good. It's always about perspective there too. Even with the cap rate market. Cap rates are higher than they were a year ago, but if you look at history, it's still pretty good. And there are a lot of people that don't think we'll ever get to where we were a year ago in the cap rate market. And that might be true. And if it isn't true, it might be 20 years down the road. Most of our clients aren't planning 20 years down the road. If you really look at where the market is, it might not be as good as it was, but it's still a good M&A market, all things considered. And if you're a seller, you still get a very competitive price for your business and your real estate, in my opinion.

Rick Ormbsy:

Let's look at two questions here and then we'll end. One of them is more technical question, which is about Opco and Propco financing. Have you seen those things? Is like, in other words, if you were going to buy a business, you finance the business separate from the real estate or as one consolidated piece. And I think the Opco/Propco arrangement is very common, very popular with the financial buyers on larger deals. Historically the property could be to borrow more money at fixed rates potentially on longer amortizations with the property. The operating company, you can get 20 to 25 years on the maybe push to 25 years on the property company. On the Opco you're talking to 10 to maybe 12 year amortization with a five to seven year term. So, by splitting them you get basically a better, the idea is you get a better balance, less risk, and you're able to maximize price and pay your notes back.

The comment I would make is in 2023, we don't really fully know this yet just because we haven't had a lot of deals to see it. But Propco financing is going to come under some scrutiny different then what it has been in the past few years. The ability to feel more advantageous by splitting them up, that advantage may become a little bit less apparent. And ultimately the thought of when we do evaluation for a client and tell them what their business is worth, we're always looking at the operating company and the property separately, and then we add them together to tell them what the client should be able to achieve in a sale. Our clients are thinking about the two separately and together. So this concept is not a foreign concept and for buyers it's one that they're evaluating. As the real estate cap rates change precipitously though, I think the property side of the equation may change.

You may see buyers keeping their real estate more frequently this year than they have in the past, or you may see them keeping it and selling it slowly over time on the 1031 market as an example. Instead of selling the real estate to the buyer who's having trouble getting financing for it. And then the last question guys, how about this? Someone, one of you guys answered this question. Are you seeing an increased level of due diligence by buyers? And how are you seeing buyers think about proforma adjustments for new and ramping up locations? That's a good question. Fire away. What do you think about that guys?

Derek Ball:

We generally, like I mentioned, we are going to be less aggressive than a lot of groups in terms of making proforma adjustments and putting big sales levels and big EBITDA in proforma locations. Generally speaking, if it's a new location that the seller is not building, obviously we don't proforma it at all. That's a seller. That's a buyer, build a buyer opportunity. A recent deal we put out there, it's a 30 unit transaction and we had zero proforma adjustments on it. So in my opinion is buyers often don't give consideration for proforma adjustments, which is why we have gotten out of the habit of putting them in there, because they get looked at very negatively and take away from the overall aspect of just an attractive transaction potentially. And they get focused on things that might be deemed unreasonable. So generally speaking, yeah, I think banks are also going to be looking to limit proforma adjustments too. I talked to the lender last week who very specifically mentioned that. Buyer can accept whatever they want, but if your lender says no, guess what? It's a no.

Rick Ormbsy:

What about new locations?

Derek Ball:

Yeah, I mean think usually when we go to sellers, we say, "What do you think it's going to do?" We take similar level sales volumes from their existing business and that's how we perform with that. But we tell them, You're unlikely to get this value at closing. Your sales are going to have to pan out within the 15 months after it opens and it'll sit there in an escrow account and earn out of some fashion. And that's what you'll get." And we tell all of our sellers that, and we very rarely see buyers being willing to offer anything else. It's one thing if you're asking for a 100-unit deal and you got two of them in there, it's two out of a 100 stores. But most deals out there, if you've got two new builds and it's a 15 unit deal, it's a pretty big percentage of the deal.

And that's going to be held back. And very limited scenarios I would say it won't be held back. But 90 plus percent of the time buyer's going to say, "I'm paying you a multiple on EBITDA that you've been able to show over the last five years. I'm not going to give you that same multiple on EBITDA on a store that hasn't even been opened yet." And that's one of the other lines of logic from a buyer's perspective of how they look at it. And hard for me to fault them, I can't disagree with it.

Rick Ormbsy:

And a lot of it's changed, hasn't it? A couple years ago people were buying stores based on these performers on new builds. Now it's a little bit more of a dissecting and peeling back the onion and asking questions of the operator. And this is what we do. We say, "Okay, well what do you think the sales will be? Why do you think they'll be this much? Are you going to own the real estate?" Maybe it's best to take the real estate and keep the real estate yourself and provide a lease that resets after month 13. You know what I mean? And then you take that risk off of the buyer who otherwise is going to be making a guess about what the real estate value would be, not knowing what the sales volume's going to be in the store. Then you isolate the price of the asset that you're building just to the operating company value.

And then maybe you're able to come to a price that's like the price that the buyer paid plus or the seller paid to build the store, plus a 10 to 15% average and then some sort of an earn out on top of it. I mean, it's a case by case discussion and Derek's, right? If you have a hundred stores and only two of them are new stores, it's a lot easier discussion than if you have 15 stores and you have five that are going to be new stores, right? Where it's a significant portion of the value of the business. Well, we are up on our time. Thank you guys and gal so much for joining. I hope you enjoyed the content a big what's up to the Restaurant Boiler Room. I hope you had a little giggle or two with the Rocky discussion. So my favorite Rocky movies, Rocky III, and we're going to have some good podcasts and good webinars coming up with some franchisees and some lenders later on this spring and summer.

So please stay tuned and holler and reach out if you have any questions, anytime you should know how to reach us. So thanks Derek, and thanks Peter. Enjoyed it.

Peter Fisher:

Appreciate.

Derek Ball:

Thanks everybody.

Rick Ormbsy:

Have a good one. Thanks so much for entering the boiler room today. You can find our podcast on iTunes, Google Play, Stitcher, TuneIn, and Spotify. If you like these podcasts, please listen, rate and review. I also encourage you to visit our website at www.unbridledcapital.com for the best franchise M&A and financial resources in the industry. Our website includes webinars, podcasts, videos, white papers, and a list of our past M&A transactions. Please note that neither Rick Ormsby nor Unbridled Capital Advisors LLC give legal, financial, or tax advice. These podcasts represent opinions that have been prepared for informational purposes only. We expressly disclaim any and all liabilities that may be based on such information, errors therein, or emissions there from.