Welcome to The Restaurant Boiler Room, season four, episode six. I'm your host, Rick Ormsby managing director at Unbridled Capital. Today in the boiler room, I've invited two seasoned franchise lenders to the boiler room to give an update on the franchise lending market. Our guests are Mike Eagen at Synovus Bank and John Dysart at People's United M&T Bank. We will be talking about the cooling M&A market and how it is affecting loan terms, lender covenant compliance, and M&A transactions during due diligence. There will also be a good amount of macroeconomic discussion and overview of restaurant revenue and profit performance so far this year. 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.

Well, it's about one o'clock. I'm thankful for those who are hopping on the numbers, people are coming on, but we'll go ahead and start slowly for the first few minutes. I want to welcome everybody who will be listening to this on podcast with the restaurant boiler room. We're thankful that you're listening or will listen wherever you are, man. I was just talking to some college students today. I know some private equity guys. Who's put the earbuds in on their way into the city on the subways. So we're thankful that you listen to the restaurant boiler room on podcast. Rules of the road here, okay, you guys can ask questions anytime you want to. The three of us will kind be watching for questions and we'll try to answer them as we can, that's the first thing. We will send out a link to this webinar, to everyone who's signed up.

So you will get a link [inaudible 00:01:55] and an email to you, so you can see it delayed if you want to, or you can forward it to someone you know. And I will also put it on our website and on LinkedIn too. So you'll be able to find it at www.undbridalcapital.com. Just hang in there and we're excited about today's topic quickly. Quickly I will just give a M&A update before we start. This time last year we had 37 deals going at Unbridle and I was just counting this year so far we have four closed, 11 in various stages of closing and four to five new engagements possible in the next 60 days or so, which puts us at about a little over half of what we were doing last year at this time. I think from all I've talked about, from all I've asked around in the industry, Unbridled has continued to skew pretty highly, but I mean, I think it's kind a general indication deal flow in the activity in marketplace this year in 2022.

It was a big year, last year so it was going to come down no matter what. And then we've had some changing conditions as well. So that's what we're seeing at this very moment at the beginning, or well, middle of Q2 and towards the end of Q2. We'll keep updating we as we go forward. And now I guess we'll just do the introductions. I'm really excited today to be here with Mike Eagen and John Dysart, both excellent long term guys in the franchise space. They're lenders. They do their jobs really, really well.

They've got great perspectives and they've got their temperature to the ground every day like I do. Their perspectives are going to be interesting us to talk to a minute ago, maybe 60 to 90 days behind mine because Mike said a leading indicator. So we see things before they get to the lenders in many cases. So our opinions here and our perspectives, I think should be fairly diverse within the structure of lending and M&A activities. And I'll just kick it off to you guys, Mike and then John, maybe a quick introduction of each other and we'll jump into the question.

Sure, sure, sure. So I'm Michael Eagen. I am now with Synovus Bank having just joined recently about few weeks ago. Been in the business, I think this summer's 24 years. So I am now one of the old guys in a room along with John Dysart. We've been here a long time, seen lots of cycles, seen everything from securitized debt to sale lease, back booms and other sorts of wild rides. But I've been an owner of restaurant, worked in restaurants, saw through college and high school, love the industry. I have grease in my veins, I like to say.

But it's always easier being the lender or the landlord when it comes to the restaurant business. And more than anything, I certainly understand how difficult it is for restaurant operators today. It is probably the most challenging time in 30 or maybe 40 years if some operators have still been running around that long. But the challenges that you face right now are extraordinary and it'll continue to be a rough ride for a few more months at least as we kind of work our way through what the Fed is instrumenting is essentially driving us towards a mild recession or a soft landing or both. Go ahead, John.

Hey, good afternoon everybody or morning as it were for me. I'm John Dysart, I run the franchise finance team for People's United Bank slash M&T. We are now complete with our merger, happy to have that behind us and moving forward in the industry. Maybe I'm the elder statesman in this because I've been in this business for over 30 years now having started it...

Oh!

I know it's crazy to admit, but I actually started it while I was in college. We were working for Buzzing Island, securitized lending industry. So I always tease Greg Flynn that I've known him since he was helping to manage his dad's Three Burger Kings. And so it's really been a heck of a ride, but love this business. We as lenders, Mike and I and some of the others really do understand it from a investor perspective. I mean, we sit across the table from you guys and from our borrowers and we know exactly, we're talking shop with them. We are not generalists.

And so I always like to tease my guys and tell them that I'm actually your largest equity investor when you look at the amount of debt capital and the capital structure, it's just that we're not structuring as equity, but we are the largest investor. So we approach it as a partnership and really look to grow it on that basis. And in return for that, we look for honesty and realism and we try to make sure that our responses and our structures and if you do get into a little bit of trouble, have realistic and manageable responses back. And that's part of being a healthy partnership, so to speak. So look forward to the discussion today. I hope we can bring some things to the table that are a little bit newsworthy and not just what everybody already knows.

Yeah, it's great. Thank you, John. Appreciate it. Mike. And the environment has changed a little bit. There's no doubt about it. Again, I see in our deals and we'll talk about this a little bit. We'll talk about commodities, have been rough, labor pressures are there, same store sales comp have been struggling, recessions, all these kind of things. We want to dial in at how that affects the M&A business and how that affects borrowers and potential borrowers for loans. And one of the things I did about three weeks ago and so the data is about three weeks old now, maybe four weeks old, but 22 lenders responded to a survey I sent out. I sent it out about quarterly and I asked like 13 or 14 questions. And I want to just kind of go through these questions and then let you guys just kind of opine and expound on them.

I think it'll be a really nice way to keep the discussion flowing. But the first question I asked that had 22 responses was, what is your opinion of the operating environment right now? And this is lender only and about 40% said difficult, likely to get worse. 35% said difficult, but improving. And then the balance, which is about 25% said normal or could get really worse. So the majority we're saying difficult and likely to get worse, but equal amounts said difficult in improving. How do you think about that as lenders? What do you all think?

I think it is definitely difficult. And I'm going to challenge you on your survey date. I almost wish you'd waited a few more weeks. So there's a couple of critical dates that exist for lenders. That's May 15th and August 15th, at least in the near term here. That's the date that covenant compliance certificates are due and that's going to be reflective of the first quarter on May 15th. August 15th you're going to be 45 days out from the end of the second quarter. So some of this isn't yet reflective of what is happening real time or certainly what we saw in a first quarter in terms of Omicron and the impact on a business. But I'd likened it to a... It was a bit of like a hurricane, a non-recurring event. What occurred during the first quarter was very unique compared to anything else that happened during COVID, you had lost hours of sales, either at the end of the day, the beginning of the day, or just in some cases, restaurants closing for a week or more.

And so you lost a number of days of sales. And I think Dominoes actually came out and quantified it into like six days of lost sales during the first quarter. So the impact was dramatic because you didn't have the top line versus say in the middle of 2020, you were able to keep the drive thru's open. People were coming in buying food. You had a skeleton crew and you were able to generate more profits probably than ever before. And then in many cases, receive PPP funds to help keep the business afloat or bolstered for the months to come. The inflation situation. I'm not going to rehash all that, everybody knows how difficult it is on inflation. It got worse on February 24th when Russia invaded Ukraine and caused gasoline to spike. The thing you've got to be mindful of about gasoline prices and even inflation, consumers can tolerate a certain amount of that, it's normal.

And when you have rapid acceleration of inflation, that's when you get wild swings in consumer behavior. So if you think about what gasoline has done over the past couple of years, it's more than doubled. You think about the price at the pump, even up 50% at the beginning of the year, that's a sticker shot and you're going to get a different reaction in consumer behavior. It shows up in the more recent University of Michigan sentiment numbers that just came out indicating that consumer sentiment at its worst, since like the early 1980s, the last time we had inflation and stagflation, it's worse than what it was even in 08, 09. So consumers are beginning to react differently and we're going to see it flow through in the months ahead, it'll show up in a lot of the data that comes out.

But be mindful, a lot of the data that we look at it is rear view mirror looking, it's not looking ahead. There's going to be a delay and a lot of that information. So on labor, I mean, everybody knows how difficult it is to get labor. I think you're talking about something like 750,000 workers are still missing from the restaurant labor workforce since COVID started. You're probably down about 70 to 80,000 restaurants, most of those independent restaurants. But the big paradigm shift that's occurred in labor. I think it's at least what I believe and what I think there's going to be some moderation on labor in the second half of the year is that you had delivery that became suddenly an incredible use case was built for it during COVID. If you tracked some of the numbers, DoorDash hired something like 2 million workers, Instacart hired 400,000 workers, everybody one and started doing things to their homes from Amazon Food, supermarkets, you name it.

That's changing. Now, paradigm is shifting. There was an article in the wall street journal a few weeks ago, talking about Instacart and how, where their workers were making upwards of 30 and 35, $40 an hour during the peak of delivery season, they're back down around 20 or $25. The incidence of delivery is shrinking for supermarket deliveries. Amazon has spoken to that as well. And then you've also got the impact of consumers just not spending as much. So Walmart, target, inventories, building where folks are not spending as much, there is a paradigm shift that's occurring when it comes to delivery workers.

You still hear about shortages that's going to prevail for a while longer, but if you get in an Uber car, talk to an Uber driver about how much money they're making now versus before. What I've taken away with some of these anecdotes is that Uber drivers who work full time or overtime will get bonus money and it will be lucrative. If they do it as a part-time gig it's not very lucrative right now between the gas, car repairs, the uncertainty of rides and what you're going to be making.

I think the appeal of restaurant work will become more attractive because frankly, wages are higher, scheduling is a little bit more stable. People can be more predictive about how they're going to make money or where they're going to make money. And I think by the second half of the year, as you get this shift of workers from more of that gig economy coming back to restaurants as more of a refuge, I believe, I think you're going to get some relief on the labor shortages and perhaps even be a bit deflationary when it comes to average hourly wages.

Well, thank you. That was a very thorough answer. Interesting points, really. I appreciate that Mike. What do you think, John? I mean just a anecdotal comments here and what do you think of the operating environment? What do you see with your lenders and your clients?

Playing off with what Mike just said, I think the key element to the labor faction in this or the labor issues are that applications seem to be up. And from the guys that I've talked to, the challenges keeping those employees. Things are a little bit different now than the way that they used to be. I mean, I have a personal friend that owns a upper scale bar and restaurant, has for a few years. And boy, the things that they're having to do to keep those employees engaged and appeal to their sense of belonging with the company and appealing to what's important to them outside the workplace is just unprecedented. I mean, look, you need to stay open.

Still, on average, 25% of chain brands are not open full hours and so that's lost top line sales that people are still trying to get back. You may not like it, but I think you need to embrace some of the techniques and things it's going to take to keep employees engaged and staying at the company rather than just moving on to go find someplace else. Wages are not the most important thing to them always in newer generations. And then kind of going back to echoing some of Mike's thoughts on the consumer sentiment, the interesting part is consumers seem to be continuing to go out to eat. I mean, maybe it's just the fact that lockdowns are over and masks have gone away and people are just going about living their lives. And that's probably a good thing. I mean, the good thing for restaurant owners is that cost of good sold are up across the board.

Grocery stores, average price is up, are up 11.9% over a year ago, which is the largest jump since 1979 while on average restaurant prices rose 7.4%. So it's not like restaurants are having to fully compete with lower prices at the grocery store that consumer desire to be out and about is still there. The question is how long can they hold on and continue to spend. And some brands have been able to raise price enough to sort of hold their profitability stable and some were slow to react.

And so I think like Mike said the Q2 is really going to be a telltale sign for these guys. And unfortunately for those that didn't do all that well, that first quarter's going to be there for a full year and it's going to affect things. And relative to how we're looking at things. I mean, look, it just means that from a lender's perspective, we're building in more cushion day one it's one of the reasons why buyers and sellers are having to go back and forth on where the purchase and sale price are. So we're going to sensitize projections more and we're going to be a little bit more cautious on the cushion for day one, leverage covenants coming in.

I would say that in our deals and thank you, John, across what we see on the M&A side Q2 has been difficult, but it's been uneven, hasn't it? So you guys will see it soon I guess if you haven't seen it already. Across different brands, it's a different story across certain brands. I mean, some of the segments have done really well actually, because they've been able to raise their prices and they're in a space where maybe their commodity that they sell a whole lot of, their type of food isn't up as much as maybe another like chicken might be up way more than X, Y, Z. So relative to chicken or inflation, maybe on the food side, not as high as other types of products. So we're seeing it kind of an unevenness across brands.

And then in our deals. And I'll talk about this a little bit more. I mean, I tell people, I say, Hey, look, if you're in the middle of a transaction, you always have to think about the way you operate your business and operate it. Even when you're selling or buying a company, you got to operate it like you're going to own it for 40 more years. I'll always ask, when was the last time you've taken pricing? And it's interesting, like a lot of folks still had this sensitivity to taking pricing and they've only done it when they've been almost yelled at by the corporate guy or by their fellow franchisee. I'm not asking every month, but I'm asking all of our clients all the time. When is the last time you've taken pricing? How much pricing have you taken? When are you taking pricing again?

There's some level you don't want your transactions to decline. And we are seeing transaction degradation across the industry. And a lot of sales growth do mostly to pricing where we have it. But at the same time to keep your EBITDA and your profitability up, you've got to constantly be reassessing your pricing structure. And that's a big takeaway. And that'll roll right back to the lenders when they look at financing these deals. They're going to look at the inflationary cost of your food and they're going to look at your labor in the middle of your P and L and then they're going to look at your sales and see what's, pricing is like and that's going to be part of the analysis that they're going to make.

Here's another question for you. And I'll start with John here. How much is your loan volume currently dropping because of rising rates? And the answers to this question were 45% said not much change. This is 30 days or less dated so maybe different now. 36% said a modest amount of loan volume drop, but it should turn around later this year. And about 20% said, it'll get worse, low and going to get worse. What's say you and what's the thinking behind it?

Yeah. I mean, look, our loan volume's down a little bit this first quarter, but that is kind of like the COVID bump that everybody saw last year that the NPC deals got funded in the first quarter of last year. So there was a big bump in volume. We saw a bunch of deals get funded in the first quarter. So we are down a little bit, a few deals that are kind of on hold right now, they have been moving around in the buyer, seller category. But in my opinion, it's not interest rates that are the cause it's digesting the performance based on the same thing you're dealing with. So it's off a little bit, but we're seeing some increase in activity and I think requiring and mandating updating the most up to date information is something that really has also been. We passed on several deals so far this year because we weren't able to get updated numbers to kind of get as comfortable with what's going on P2, P3, P4. I think until that happens, our deal volume will probably pick up a little bit.

We're all hoping that once we got past like P5, we'd kind of be past the third round of stimulus from last year. So sales, we expect and hope in P6, P7, P8, absent some tough situations. They should get better on a year on year basis. It's the margins. We're getting more calls now. In the last couple of weeks, I probably had calls from six or seven folks looking to sell and one or two looking to refinance their business for one reason or another, which is more than normal, maybe above normal for a normal year, but way above normal for the last four or five months. So I think I might answer the question that it could be turning around later this year. I think it's any man's guess what do you say, Mike?

Well, I've been tracking since November 1st on loan volume, Synovus Bank is pretty new entrant. Scott Tocci and myself have been in the space for decades. So Scott's been there about a year and beginning to bring on large pieces of other deals, leading some whole lender deals as well. So the future is bright for us. The challenge you see is that since November, I've seen about 13 deals of larger franchisees that have unraveled when it came down to a letter of intent is issued. They make their offer, the new numbers come in for the last three months or so. And there's a discussion about, look, I need a purchase price adjustment. I'm not going to catch a falling knife. Your EBITDA's down 10, 15, 20%, sellers don't want to capitulate and give on that price. And so deals are unraveling and these are deals that are 5 million of EBITDA or higher.

And I would tell you there, there seems to be a concentration in a couple of burger brands where it's been hit the hardest, maybe on a price of beef, more than anything. I would tell you it's across the board though. It's in Mexican, it's in donuts. And there are a lot of deals that can't come forward or certain brands that can't come forward because their EBITDA margins are slipping down below 5%. Like it's really, really hard to get a return on investment and sell your restaurant company if you're generating a corporate EBITDA of less than 8%, because there's not enough money to flow through, to not only pay the lender, pay the landlords, do your CapEx, but also get a decent rate of return on your equity, which is a big equity check on these days because the lending community will lend 50, 60% perhaps on a deal.

You got to write a big equity check. And so what I think was happening right now, we're in the midst of the falling knife. Nobody wants to catch that. You're going to wait till it hits the floor and you're going to find a bottoming out. And I do think you're lapping some extraordinarily good EBITDA numbers. From my perspective, as a lender, I feel a whole lot more comfortable lending on the trailing 12 months, end of June or September of 22 than I did last year. It's the function of you have had an extraordinarily good margin, highest volumes in sales you've ever had in many in years. But I often joke and say, the word capitulation is really, really big five syllables, lots of letters, hard to spell and really hard for sellers to swallow.

Capitulating and accepting a Fed, the valuation is not going to be what you thought it was a year ago. Buyers are not going to take that risk at the same levels. And they're going to expect you to either work out and earn out, reduce the purchase price, hold seller paper that might be conditional on some level of performance. I think those are reasonable types to think about when you're a seller, if you actually want to transact, if you're a motivated seller, let's put it that way. If you just want to kick tires and go on a fishing trip to see where your companies work and Rick, you'd probably attest to this. You don't have the time to do that, you want to make sure folks are closing. And I think that really requires motivated buyers and sellers that'll come to an agreement that makes sense. But we're in that period of flux right now, until we find this new equilibrium between buyers and sellers, that bid ask is going to gap out a little bit.

Yeah, yeah. There's no doubt. That's right. Our group, it takes kind of relatively few assignments at a high degree of success. So we have those discussions on the outset that are pretty brutal discussions. It's like, Hey man, if you were taking algebra one, and you wanted to sell last year, you got a hundred on your algebra one test right now, you've got a 70 probably, you know what I mean? A C-minus in terms of the time to sell. So that, I mean, the good old days were a year ago and the good old days aren't right now. Now what will happen in the next six months or 12 months or 18 months, many people think it's going to get worse. So my pitch is always to people. Look, I mean, if you think your business is worth what it was last year, it ain't, it ain't worth what it was last year. You're going to have to suck it up and get over it.

Many cases, there are some companies and some brands in particular where they're actually kicking butt and they're worth just as much or more because there's not as much supply and there's more demand relative to the supply, but in many cases, your business isn't worth as much. And so you can't go into a process thinking that it is, or you're going to risk the confidentiality of your team and the trust and confidence of your family and all the things that are important and dear to you. So you really have to be realistic with it. And I think in this environment too, man, I mean, like you said, a lot of the bigger deals are going to fail and they have thought and failed. I think we're probably towards the end of that because I think we're probably coming into a little bit of a bottom where things are getting adjusted and there's like this equilibrium that you're talking about. But in that kind of an environment, you see financial buyers backing out of deals because they're really mostly concerned just with the goggles of EBITDA.

You know what I mean? EBIDA, EBIDA, EBIDA, right? That the strategic buyers, the ones who buy the small and medium sized businesses can look past a bad quarter. They know that the band team plays and works in the store over in Nowheresville, Iowa. And they know the manager and they've known the manager for 30 years and seen him at the co-op meetings like that. They know that business is stable and sound and can look at it more strategically. So I think you'll see maybe a resurgence of strategic buyers and maybe a little bit of a pause on the financial buyer's side as we go through the...

The other point I was going to make, lenders, how are the lenders are going to react to this new deal flow? I mean, the reality is both John and I, we make a really good living when there's lots of M&A activity, because that creates new opportunities for financing. We don't have a lot of success trying to pull one loan from the other banker's balance sheet and back and forth because most lenders are going to be very defensive about keeping the book that they have, especially the performing book. While at the same time, they're going to be experiencing some of these covenant waivers. The banks will be wavering, lets put quotes on that. They're going to be handing out waivers, they're going to be dealing with compliance issues. They're going to have to explain to folks up above that what was a good loan or appear to be a less stressed loan a year ago is now stressed.

That's going to create some difficulty with the credit shops being willing to be as flexible as they had been say a year ago when there was still trajectory north. Unfortunately, there's this paradigm that I won't say negative things about credit folks, but they like to do a sort of a linear regression forward of the last data point. And so if it's bad, it goes down onward forever. That's not the case. I would tell you also that with respect to most of what we do is fast food restaurant lending, versus the full service restaurant. Jonathan Mays did a really good piece today. It's in restaurant business online talking about the recession resistance of fast food restaurant businesses. And he went back and looked at how they performed in 08 and 09. And the brands that actually comped positive brands like Taco Bell and Chipotle and in others that are in the fast food business.

I think that's a great read. It's also good reinforcement as to what will happen next. I do believe the QSR business is going to continue to be resilient. They're going to get the trade down from some of the more expensive options out there. And I really do think a lot of consumers are going to opt to not pay the delivery charge, the premium pricing that's online for some of the third party deliveries. And I believe people are going to get back on a drive thru and go pick it up. I mean, Toast just published some numbers indicating that in store dining is up 46% in the first quarter and delivery is down 7%. So I would challenge every operator out there, take a look at that empirical data what's happening with the third party delivery, if it's actually starting to decline, that'll be your first signal that there's a shift in consumer behavior. And especially if your drive thru transactions start climbing as well.

Yeah. [inaudible 00:26:46.]

That's a good sign.

The American Consumer proved during COVID, if it proved anything, Americans do not like to cook for themselves. Everybody went out for the first three weeks and cleared the grocery store shelves and tried cooking and realized a couple of weeks later that they really hate cooking. And so they started coming back to the restaurant. So I do think that's sort of a positive and does prove out that recession proof mentality that QSR and restaurants in general have.

John, you brought up a good point 11.9% increase at the grocery stores, 7.9 or something like this percent increase in prices across the food establishments. But I tell you, I'm starting to get a little cagey about rolling through the drive through line. And I eat a lot of fast food, probably not good for me, but you know, it's part of what I do.

Market research.

Market research, right. You know, the pricing, man pricing, I'm choking on it a little bit like my kids, oh, let's go to Chick-fil-A. And all of a sudden, at the end of the month, they went to Chick-fil-A eight times each times 16, and all of a sudden I've got like a $240 bill from Chick-fil-A. I'm like, God, Hey, it's like 12, $13.

Now Technomic puts some research out on this I think back in April talking about how the average drive thru ticket price is about 10,08. And it's funny, cause I tell most operators that the QSR are like, oh, mine's over our left. So certainly folks are getting more out there, but there is this psychological break point at $10. Consumers may be trading, instead of trading down, trading out. Everybody likes the talking heads, like to talk about all this excess savings two and a half trillion dollars that have built up since COVID. It's not in the bottom 60% of households, which are more of your heavy users of QSR and that sort of thing.

So people are struggling, there's going to be challenges and I think the next wave that come, this is the next challenge for fast food restaurant operators, franchisors are going to want to push value and dollar or $2 menu type strategies. At the same time, everything is climbing in terms of labor and costs to get sold. And very rarely do they make it up on volume. And I think that's going to be a difficult part. They want to afford positive comps. And so you do that with value or discounting, limited time offers those kinds of things. That's going to be a challenge for most restaurant operators. If that's the way we go.

Once you hit the crack pipe, it's hard to stop. You know what I mean? With value. That's the problem with it. What do you say, John? I mean, John and Mike, both of you guys, how many franchise M&A deals are you personally trying to fund right now? At the time I asked this, we had 50% said zero to three, which is surprisingly low. We had 40% basically said four to six. And then the last 10% were like somewhere around seven or eight. Where do you guys land in that pie?

We're working on three right now. Couple more have gone on hold. That's just pure M&A deals. We had a couple that sort of came and went earlier in the year and it wasn't that they may not have gotten done. It was just that they were at levels where we couldn't get the due diligence we were looking for at that particular time. So maybe the existing lender had to step up and over fund a little bit or something like that. So three right now with a couple more sort of on hold and may come back around.

Okay.

I'd probably say there's a couple of proprietary things that are out there, there's a couple of wider options. So maybe three or four that are sort of happening right now, but the robust 15, 20 bidders on a multiple deals in some of the top QSR brands that ain't happening. I don't see right now. I think if you look at... To get your answer why, take a look at a couple of the publicly traded fast food guys and I won't name names and throw stones. But when first quarter EBITDA is down 35, 45% year over year, it's really hard to go to market and try and get a fair price for your company. And that's got to moderate before that this picks up again. So I'm not sure where the numbers were coming from. I commend those bankers who are hustling out there finding that many off market deals, but we'll see how many close by the end. I'd love to see update this in September after folks get their August numbers in and see how things pan out, they hold up. That'd probably be my challenge for you.

Two points on that. I spoke to a couple of operators yesterday, one more of a mid-tier direct owner operator. Who's got plenty of capital, but no private equity partner. He's literally on the sidelines for the remainder of the year. Not going to look at any more deals, even, even tuck in deals, bigger group, more well healed across multiple categories, definitely in buying mode, those buyers will continue to look for those buying opportunities.

Yeah. I don't know that I've seen a whole lot of difference in terms of the amount of offers and businesses. And here's the reason why, let's say you have a bucket of 10 buyers, I mean for a business like two or three of them are saying, it's not the right environment for me now. I don't want to grow, but those remaining seven are still in the bucket. And there's not as many opportunities as there were in the last couple of years right now.

So if you are wanting to buy something and you feel like you can buy it at a reasonable price, there's not a lot of opportunities for you because there's not a lot of deals on the market. And then not a lot of sellers are reasonable. There's still stuck in 2021. So we just had like a 25 unit deal on the market, had we done business in this brand a lot over the years. And traditionally it would've had probably three or four or five offers on it, but we had like six offers on it and they're competitively priced. So that's just one anecdotal case. It was kind of heavily marketed on our end. So we saw just as many buyers, maybe more. And I think it's because the opportunities haven't been there

Just to add to that too, Rick, the lender marketplace is ready. If the deal is right, I mean, every deal Mike, you've seen this, every deal that's a syndicated deal is meaningfully oversubscribed. So the lenders that are in this space have plenty of capital to deploy. But I think the good news is that a lot of us that are in this space that they're kind of running these franchise shops have been around long enough to know there's going to be limitations on how aggressive we can get right now. But there's [inaudible 00:32:42] hundred dollars available and demand.

Yeah. That's great, John. I mean, let me follow up with a question, like how do you approach lending to a business through Q2 of 2022? I mean, how do you think about that, your risk guys? Let's say 2021 was a banner year, second half of 2021 started to see EBITDA drop a little bit, but sales are still fairly strong. We get into the first quarter, sales and profits are down and then it gets worse in the second quarter let's say, because mostly because we're rolling over such strong numbers from last year, how does your team look at that? How do they look at the making a loan? What do they think?

Well, I think that the key to it right now is making sure that we're lending off just like the buyers, we're lending off of the most recent numbers. And a lot of people are waiting for those solid Q2 numbers to come in, to see in the brands that maybe waited a little bit to take price and then more aggressively took price. How much is that going to flow through to the P&L and actually stabilize EBITDA a little bit. I mean, we do a statistical analysis, statistical tracking, excuse me, of our leverage changes in our portfolio. And it's something like 60% of our portfolio has seen more than a 25 basis point movement in leverage. And in some cases that's 50 to a hundred basis points and that's from Q3, Q4 into Q1. So what that's resulting in is a need to build more cushion in, into the day one, leverage numbers and beat up projections more to make sure they're going to be able to manage the downside case.

Do you guys build in and Mike, maybe you can answer this. How much credence do you give the future EBIDA increases due to pricing? Do you guys look at that?

We don't get paid enough to take equity risk. I mean, that's the reality of it and that's been true for honestly decades. I mean, if you go back to the days of securitization, when Taco Bell guys could borrow 110% of the value of the acquisition and there was very loose underwriting back then you could underwrite price increases. And the reality is it oftentimes doesn't materialize. And that's the difference between, if we get paid spreads that are in the two hundreds and maybe three hundreds over a floating rate at a high side, you are not getting paid enough to take the equity risk that is required of that sort of guessing game. Cause the reality is you can look at the empirical data right now, guys are taking price and they're losing traffic. And so there is this offset who can accurately predict that.

And you're doing it at a time when you're talking about peak pricing where you're really pushing the envelope of what consumers could afford, that's not going to happen. To answer the rest of your question, I think what's going to happen is I've seen in prior cycles, like we're going to continue lending money, the banks still want to lend money to the fast food restaurant business. They'll be more cautious with casual dining, for sure, because that paradigm is still shifting. And as a secular change was happening for over a decade prior to COVID, it's going to resume at some point, delivery is still not as profitable as it needs to be for those guys. So if we're lending into fast casual and fast food operators, I think what you end up going to doing is you're going to see a quarter point reduction in maybe the leverage. And so if you think of most restaurant underwriters are going to put together a financing and a term debt upfront that gives you at least a 15, 20 preferably 25% cushion before you trigger a default.

Another way of saying is that your EBIDA can fall by 20% before you trigger your lease adjusted leverage covenant, which is almost always the first covenant to go. It's not the FCCR's or the cash flow coverage or debt to EBIDA per se, it's the lease adjusted leverage. And so I could see that ratcheting back a quarter or in a half turn in certain brands, especially the ones that have drifted back to single digit corporate EBITDA margin. People ask, why are you leveraging Taco Bell so much more aggressively than say Burger King or some of the other burger chains? The reality is that Taco Bell operators, at least the past few deals I've seen have reached 20% corporate EBITDA margins. Generally speaking, the burger guys get about 10% corporate EBITDA margins. So you can see the cushion that to the downside, it's much more magnified when you have that much of a less corporate margin.

I mean the old rule of thumb was that if say same source sales fall 4%, you might wipe out 200 basis points of your corporate EBITDA margin. So if you're at 8%, you might take a 25% hit to your EBITDA. So that's what I'm talking about in terms of the cushions that most bankers underwrite to. And those cushions will get wider until they get a sense of we're reverting to the mean we're returning back to normal levels of corporate EBIDA. So I see that occurring more than lenders, just throwing up the gates and saying, we're done, we're not lending. It's just going to be a bit more conservative.

Does that sound right with you, John? I thought I heard Mike say so if you were lending 5.75 times at least adjusted leverage on a tier one concept, you might be at five and a half or five in a quarter at some point to be more conservative. Does that seem reasonable to you?

Yeah. Maybe that kind of tackles the category of has your underwriting gotten tougher? And I think we certainly look for more cushion right now 25 to 50 basis points cushion in day one funding just like buyers don't want to finalize their purchase price on a falling knife EBITDA. As Mike said the last thing we want is to close on a deal at a two aggressive day one funding level only to find ourselves in default after one or two quarters of funding that loan. And so that's the reason for the sensitization that Mike talked about to make sure that all of a sudden, maybe we used fund at a 5,75 per taco bell, and you look two quarters out and all of a sudden you're at 6,45. We're going to want that cushion to make sure that the downside case can support not going up over that covenant levels.

We're okay setting those covenant levels up at those higher levels still, but just the volatility of cash flow has been just much more meaningful these days. And so that's why buyers are writing bigger equity checks. It might be the right spot to talk a little bit about as lenders we have to deal with and maybe not the broader audience would understand is that as franchise lenders we deal in a leveraged lending world, which is designated by the regulators. Going back to the financial crisis, when all the subprime loans blew up, they introduce legislation known as the Dodd-Frank Act, which essentially put a broad brush categorization of what is considered leverage lending, which is over three times senior and over four times committed debt.

Well, you go in and look at a franchise portfolio or the history of franchise lending and... We're always above that leverage lending threshold, but what that means for us, we've gotten comfortable as an industry, but the regulators hold you to that level. And you have to designate your loans as a leverage loan, which means you're reserving more against it, you're under more scrutiny in terms of what your leverage loan portfolio looks like. And so the ongoing monitoring of that by the regulators is definitely in play. So we as franchise lenders have to have that balance of keeping our risk department comfortable and our leverage lending portfolio comfortable. That's one of the reasons why we have to look at how the day one leverage looks and that it doesn't go. Look, we told everybody, look, you got to be comfortable at 600 quarter lease adjusted leverage as long as everybody stays under that. Well, if 70% of your portfolio goes over that, then that's going to cause some problems.

Yeah, yeah. No, thank you for that. No, it's good. It's good. The high level explanation. I think it's probably time to, maybe for me to interject a little bit on cap rates, because as we talk about M&A transactions real estate's are component of a lot of what people do. And while the lenders here are telling you that they're getting more conservative and they're underwriting slightly, at least by showing of this survey, the cap rates move kind of in concert with interest rates. They don't move exactly on a day to day basis, but you can expect as interest rates rise that you're going to see cap rates become worse as well. And we're starting to see that in some of our transactions. So we just had gotten wind of a couple of deals where there was just some re-trading of the cap rates by 25 basis points prior to closing.

And I think someone actually, a friend and a client told me that on one of their transactions, he might be listening to this webinar right now, but we're seeing a little bit of that. Some pressure on the cap rates, buyers coming back and saying, Hey, interest rates are rising, this investment, this purchase I'm making is too high. I'm going to drop the price by quarter of a cap rate, quarter of a point. And that can be meaningful if you're trying to sell a huge swath of real estate at once. If quarter point cap rates a pretty substantial thing could be millions of dollars on a big deal. I think this week, isn't it? We're going to find out what the Fed's going to do. Probably going to raise interest rates by 50 or 75 basis points. I hear Mike Eagen bowing at the mouth to answer that question.

So that's going to be more... So when you have real estate, if you're a franchisee watching this and Mike, it's your floor, yours in just a second, if you're a franchisee who has real estate and is looking to potentially sell their business at some point in time, it is likely if you have a lot of real estate, that real, estate's probably 70% of the value of your overall enterprise. It could be more even, it could be less, but let's just say it's 70%, 75% way more than the value of your business. If you own the real estate too. So interest rates are going to affect the cap rate, which are going to drop your real estate value pretty quickly, way more so than what these fine gentlemen are going to deal on the business side.

So I used to be a sell lease back guy back in the mid 2000s. We were originating when sell, lease back rates, cap rates were declining, which is a good time to be buying dirt. You can turn around and flip it for a gain overnight. And what I found back then and I've written about in the past is that the historical gap, the spread between a 10 year treasury and a cap rate for triple net lease, real estate in terms of, I think, fast food restaurants, Taco Bells and so forth. Taco Bells are pretty much get the lowest cap rate out there. It used to be like 400, 500 basis points between the 10 year treasury and that cap rate. So we've got a 10 year treasury that's about to break three 50 and folks are complaining about a 25, maybe 50 basis point increase in cap rates.

Compare that to the fact that the 10 year treasury has gone up probably 200 basis points in a very short amount of time. So on a scale basis, it's not that much of a change. And I have spoken to a couple of larger [inaudible 00:42:47] that focus on these properties. They're not gaping out in lockstep with the same way rates are going up. And the reality is that it's a function of what the Fed's trying to do right now. They are increasing interest rates and quantitative tightening in order to pop the bubble, the asset bubble that's existing now in real estate, they primarily end the stock market and things like that. And they're certainly getting the reaction they were asking for. We'll see how wide or how magnified it will be given the amount of debt that's in the system, but don't lose sight of that fact.

Before the great financial crisis in 08, the Fed's balance sheet was about $1 trillion. By the time COVID hit, pre COVID, there were up to $4 trillion. Today that balance sheet is $9 trillion. And you guys have heard me talk about this, trying to quantify what a trillion means. You count backwards 1 trillion seconds, that's 37,500 years ago when Neanderthal men was dying off. So that's a trillion seconds. We throw around trillions like it's billions, right?

Really! Really!

Oh yes. So think about the scale of what we're talking about. And what's occurred. There is so much debt in the system and this is my macroeconomic view, kind of creeping into our discussion here. But pre pandemic U.S. debt to GDP was like 107%, very high, uncomfortable. It's 137% now, okay. That much debt cannot sustain high interest rates and what the Fed is doing. And they understand this is that they have to pop the bubble. They have to stop inflation because there's a famous quote that it says something like people are nine meals away from anarchy and mankind is something like nine meals away from anarchy.

So like you can't have wild out of control food inflation. You will have civil unrest and riots. So they have to stop the inflation. It will cause a recession, it's almost guaranteed. Powell is a student of Paul Voker, he's looking at what happened back in the early 80s. And that's how they killed the dragon of inflation was a back to back recession. But I tell you this, there was nowhere near that much debt that we have today, back then.

This is an experiment, I'm not sure what happens, but I think what will happen is after they achieve the popping of the bubble, they will pull back on interest rates and they're going to have to reverse in order to stimulate the economy again, out of what will hopefully be just a mild recession or in the coming six months, we'll say. That's my prediction. So I don't see cap rates wildly tracking up the reaction you're seeing in the bond market right now. And certainly in the short end of the curve and the yield curve just inverted yesterday, which is another signal of recession. I think it's transitory to borrow a term of Mr. Powell.

The one benefit that the single tenant market has had is the demand is so great. I mean the amount of investors that can buy a triple net lease, obviously you've got your rates and your big investment funds out there and all of that, but there's a lot of people out there that can invest in a $1.7 million Taco Bell in Nowheresville, Kansas. They don't care. It's a triple net lease, they don't touch it. They're just trying to avoid cap gains and they want to roll over there. 10,31. So that demand, I think, has always helped hold cap rates and hold real estate values for the single tenant market. But when you start to factor in some of the things that are going to affect the economy and the consumer and the restaurant owners, which are the people listening in on this call, the idea that the Fed is going to continue to raise interest rates, to pop that bubble, I agree with that.

I think where it gets concerning is that the rising of interest rates could crush small businesses and therefore trickle down to consumers. Unemployment is low right now. So people still have dollars to spend. Yeah. You were spending $50 on a tank of gas before, now you're spending 75, 85. And for the average QSR consumer, that's a couple of visits a month. But Americans like to eat out, so as long as they're employed and we don't see a major reduction in the employment market, I think our QSR guys, and even our fast casual guys are going to continue to see food demand. I think where we potentially get into trouble is if the rising of interest rates starts to crush small businesses and people start to lose their jobs again. So I saw a statistic that consumers have increased their credit card usage on buying gas by 2% in the last month. Annualized credit card uses in April was 19.6%, which is pre pandemic level.

Booming.

Does that show consumer confidence or does that show that people are willing to spend no matter what, because they're just tired of not living their lives. And eventually that merry go around is going to stop. And I think that's where everybody's holding their breath a little bit about what's going to happen in the second quarter whether a true recession is out there.

Yeah. I'm going to pile on with John's comments there with the consumer credit card utilization. That's a stat I watched, the other big one is personal savings rate. That number spiked to like 33% in the middle of 2020, because nobody was spending money on anything. They had too much cash. That number historically has been between six and 8%. We just printed at 4.4 last month. And the low for that personal savings rate was 2.5% in like the middle of 2005. And then thinking about what was happening in 05, people were starting to use their home equity lines like ATMs or their homes like an ATM and flipping properties. And you had this extended run up and the economy continued. I don't think that's going to happen this time. I certainly not. I don't think people have the availability of credit that they used to back then. So consumers are going to have to make some tougher decisions. The trade down to fast food restaurants. I still believe is where they're going to go because everybody wants a small indulgence, a Starbucks coffee or a burger or whatever it may be.

The good news too, is that work from home is here to stay. So people are going to choose to stay at home more and not spend as much on gas and still stay employed, which means that they have more dollars to spend going through the drive through. But we can...

I hear you guys. And I want to like jump off a cliff, but I'm reminded of a song by old dominion. It's a country group and they have this song that's called, I was on a boat that day. And the song is about this guy and he's having a hard day and he grabs his cell phone and he just wings it into the water and then he goes off into the sunset on his boat. And then I hear all these statistics. I'm like, oh crap, get me on a boat that day. You know what I mean? You guys, man, you guys are working me.

Well, I have to laugh because Rick and I, we were talking last week, we were going back and forth and you go back to the middle of 2020. We did a webinar together and Rick was incredibly positive and I brought the black hood and the circle and it was all doom and gloom. And we flipped roles now. I'm actually like pretty bullish about where we're headed, because I feel like this is the reset that we really needed. And whether it was valuations or EBITDAs, there's going to be a reset to a new low perhaps, and you build off of that. I mean, that's healthy. Everything cycles, nothing grows to the sky. Trees don't grow to the sky. So at some point there's got to be down cycles. That's healthy. There's got to be a shakeout.

You 're seeing it in the stock market, you're seeing it in the crypto market happening in real time. The layoffs are starting in some of those industries. If you look at some of the stats, small businesses are starting to lay people off to. There's signs, the reset is happening and hopefully it's going to be short term and that the Fed will do what it needs to not make it a deeper recession, especially in an election year. But they have to do this. They have to pop the inflation bubble. The supply shock impacts the exogenous events that are happening. Whether it's oil, wheat, that sort of thing. Look, the Fed can print money really, really well, but they can't print silicon chips, wheat, oil, baby formula. All this stuff is just supply shock stuff that's going to have to work itself through over the coming months. And hopefully it's not an extended period of time.

Amen. I got a couple of things that I want to ask, this survey, let me just summarize the rest of the questions, these survey. Some deals are getting retrained now in due diligence. There's no doubt about it. You make a price, I'll say you're going to pay someone $50 million for business and you go through due diligence and performance has changed pretty wildly over a period of time. And the price has to get renegotiated, in many cases. How many deals are falling apart? It's kind of the answers were all over the board there, but it was clear from Mike's answer that we're all kind of seeing deals that aren't making it. And at Unbridled most of the deals that we have are going and if not stopped, but I screen really hard on the assignments we take on the front end.

So that's part of the reason why, but has your underwriting gotten tougher? You guys have heard that here a little bit, most of the answers here were saying, yes, it's getting tougher, probably because of the environment. What percentage of your loans are out of compliance? Most people are saying not much, but I think that's changing. We'll see that in Q2, there's been a shift in the lenders saying that they're more interested in tier one smaller deals with lower leverage, as opposed to larger deals with high leverage or larger deals in tier two brands. That was kind of a meaningful and interesting change that might be because of sample size. But it kind of told me that maybe lenders, there might be something to that, there might be a kind of during this time period, the small and mid-size deals that are lowly levered, or be the ones that are more prevalent.

And I saw, it looks like of the brands that they're most positive in the lenders 21 responses. It looks like pizza is the least favorable. And second least favorable is burgers then chicken. And then specialty was the one that they're the most favorable one. And then we see interest rates and amortization in terms or, or areas that the lenders are going to be getting more scrutiny into their loans. I have two questions and you guys can answer this and I'll let answer the last one. It answer the question. Is this, what advice would you give to borrowers right now? So I'm going out to, whatever I'm doing, whether I'm refinancing my company, whether I need to borrow money to build more units, whether I'm going to be buying my neighbor's company, whether I'm a big family office, I'm getting into a second brand kind of a broad level, both you guys give me some advice, you'd tell your clients.

Yeah. I kind of reiterate, got up on a stage in front of the RFDC conference in 07 was crying of gloom and doom of what was about to happen with mortgage rate resets. And my conclusion that is what it is today. Build your cash file, build up your credit facilities, put your cash together, get your operations home. There will be an incredible buying opportunity. As things start to reset, there will be some wreckage and folks that are going to file for bankruptcy. So there'll be some good buying opportunities. And I think just be prepared for that and be prepared for the fact look, reality is bankers and I said it then, and I'll say it again. I hate to say it, but they will lend you their umbrella when the sun is shining, they want it back when it starts raining. I prefer to just wear a rain slicker all the time.

What the heck?

I love the rain. I love the rain. Just bring it on. I think [inaudible 00:53:47]. That's when opportunity comes.

I tell you.

Yeah. But be prepared for it. Don't be a really good buying opportunity here when things get pretty grim. Be greedy when people are fearful.

Good points. Good points. Mike, what do you say, John? Thank you for that, Mike. Thank you. John.

Two things to add to that quickly, one, thank you borrower marketplace for being judicious with withholding more cash on the balance sheet, we've seen a real resistance of borrowers to want to distribute a lot of that cash that built up because of PPP funding and strong performance last year and most have held cash on the balance sheet in order to sort of see what's going to happen next. And that's really helping keep us lenders comfortable that I keep telling my credit guys, don't assume that these guys are going to always have this much cash on their balance sheet, but the good news is that they do.

So if a leverage government pops for a couple of quarters or whatever, that's okay, cash flow and liquidity look good. And so keep up that discipline. And secondly look to kind of maybe just be a little patient to see what happens in Q2 and early Q3, because I think a lot of brands and whatnot sort of learned the hard lesson of Q1 and not reacting quick enough. And I think we're going to maybe get to a steady state of what the operating levels are going to start to normalize a little bit by fixing what happened in the first quarter. And so let's see how that settles out a little bit.

Well, thank you guys. I'm going to answer the last question myself, which is what advice would I give to buyers and sellers? And I'll start with sellers and I'll say if you're a prospective seller I would just say, get realistic of what to value your businesses at this time. I mean, let's make sure that you do that before you make a decision to compromise your business and put it on the market, just to pull it off. If, if you don't achieve what you want. And, the other thing I would tell sellers is if you have a business and you're confident of what it's worth, there's not a lot of businesses on the market. So if you think things are going to get worse in the next 12 to 18 months, I kind of think they might, I might be wrong.

And you're still at a 70, 75 out of a hundred right now. And if it's a 50 out of 118 months, you would've made a better decision to sell now because there's not a lot of inventory nor a lot of distress in the marketplace right now. So that is the supply demand scenario is good for you. On the buying side. I tell you, in an environment like this, if you have capital and you have assurance of close, you're going to be looked at a lot differently than you were maybe 12, 18 months ago when no one worried about borrowing money and getting it to the closing table. So, if you're a buyer, think about how you can present yourself to seller, to eliminate their fear or the risk that the deal will get retraced or that the deal won't close at all. And if you can do that, you're going to be successful in your M&A activity. Okay. So thank you guys so much for everyone who watched.

Thank you, Rick. Yeah. Appreciate it as always. I love our entire dialogue. Really good to kind of recap where we're at and where we're headed here and thank you for the opportunity.

You're welcome.

It's been great. Thanks, Rick. Appreciate it. Appreciate everybody else out there listening in. And hopefully you learned a little something new, but if you haven't or you have other questions you guys know where to reach us.

Yeah. Thank you all so much. And thank you for listening on podcast too. You'll be good. Until next time.

All right. Take care.

All right.

Take care, guys.

See you all.

Stay hungry.

Woof. Woof.

Thanks so much for entering the boiler room today. You can find our podcast on iTunes, Google play, Stitch, or Tune In 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 a 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, their end or emissions there from.