Where's the growth capital now?

Even when there are tough financial time, money to grow can be found.

An ill wind blows through the economic world, and some fallout is settling on foodservice. “This is absolutely a perfect storm of macro-economic and restaurant industry headwinds,” says restaurant finance consultant Mark Saltzgaber. “It’s the worst I’ve seen in 18 years.”

Consumers are spending less, he notes, while food and energy costs climb and a credit crunch makes it harder to borrow money.

But even an ill wind can blow good for some. The restaurant credit market has not withered as much as other zones of finance, such as home mortgages. A January 2008 survey of 22 leading franchise lenders by Restaurant Research found their total lending capacity has dropped only slightly, from $13 billion in 2007 to $12.8 billion this year.

“There is still money available,” says Restaurant Research’s Wally Butkus. “Of course, it’s not as easy as it was. Lenders have tightened their lending criteria. They don’t want to see pro forma numbers, but real numbers. Deals are getting done. They just have to make sense.”

Small chains have one advantage over larger ones. They can close deals more easily, because lenders don’t have to syndicate pieces of the deals to other banks. Says Quinn Hall of the Restaurant Group at Banc of America Securities, “A small- to medium-sized chain with strong unit-level economics and a good story to tell can still raise growth capital.”

Here’s how to raise capital in today’s money market.

Know what lenders want
If you resisted the expansion frenzy of the past few years, you’re sitting pretty. Lenders are drawn to stable balance sheets and shun chains that are heavily in debt. Says Trey Brown, senior managing director of GE Capital Solutions, Franchise Finance, “We’re looking for durable brands that operate profitably and have levers to pull for managing their operating models into headwinds.”

It also helps to be in the right niche. As consumer confidence drops, so does investors’ interest in casual dining. For the moment, quickservice is king. “The overall economy is causing a tremendous trade-down phenomenon,” says restaurant consultant Steve Himmelfarb. “Casual dining is trading down to fast casual, and fast casual is trading down to fast food.”

Lower your expectations
No matter how catchy your concept or how strong its sales, you’re worth less to lenders and investors than you were a year ago. That’s because they typically calculate financing as a multiple of cash flow. And industry multiples have dropped.

How much less is a lender willing to loan? Let’s say your earnings, after operating expenses but before interest payments, taxes and depreciation, are $10 million this year. At 5 times cash flow, a standard multiple a year ago, your total debt could be a maximum of $50 million. At 4 times cash flow, a realistic multiple today, you could borrow only $40 million.

Expect financial covenants to be tougher, as well, with faster payback periods and less fluctuation in ratios like debt-to-equity. “Terms will become more stringent,” says Chris Thomas, CEO of the buyout fund Restaurant Acquisition Partners. “Private equity types will want to put on more terms or conditions to protect their downsides.”

The silver lining is that interest rates have declined, along with everything else. Restaurant Research reports the average restaurant loan is charging 7 to 8 percent, down a full percentage point from a year ago.

Hang on to your partners
It’s easier to borrow from a firm that already knows you. In troubled times, it’s even more important to keep existing relationships strong. “Treat your lender as though they have a board seat,” advises GE’s Brown. “Any situation you would discuss with your board...discuss with the lender.”

If you’re in danger of breaking a covenant, ask your lender about modifying terms or restructuring the debt, he adds. “Internally, we’re calling this the Year of the Amendment. We’re motivated to see investments play out, and we’re creative in helping to re-engineer a plan for unforeseen circumstances.”

Buy instead of build
Seek funding to acquire and remodel existing properties, instead of building new units. For investors, it’s a chance to buy low. “Typically, in these cycles, this is the time you want to be buying other restaurant companies,” says Saltzgaber. “I think there will be more buyouts and bankruptcies this year. There will be greater opportunities to buy existing restaurants for conversions and to buy entire companies.”

Agrees M. Steven Liff, managing director of private equity firm Sun Capital Partners, “There are a lot of attractive opportunities out there. You see a restaurant chain you can buy today at a low multiple, versus something you would pay a year or two ago.”

The key is to line up funding early on. “To take advantage of lower pricing, the most important thing is to have a bunch of cash,” says franchise attorney Dennis Monroe.

Borrow outside the box
If you can’t squeeze money from a bank or an investor, ask the seller to carry the note. Himmelfarb recently helped a client buy a dozen fast-food units in Pennsylvania from a seller who’s financing the deal himself, as a source of steady retirement income.

“My client is doing some upgrades, and he’s been able to get an equipment loan from equipment manufacturers,” says Himmelfarb. “So it’s sort of a self-financed project.”

Don’t overlook money from landlords, he adds. If you lease an endcap in a shopping center, you can get a tenant improvement allowance upfront. You’ll pay it back later, as part of your rent.

Think small
While many banks are trimming their sails, Small Business Administration lenders forge ahead. In 2007, loans under its 504 Program rose 10 percent, to $6.3 billion.

At Mercantile Commercial Capital, an SBA lender in Florida, president Christopher Hurn has other banks sending him deals they can’t afford to finance. “The people we would normally compete against,” he says, “are in a mess from the mortgage-backed securities markets.”

The 504 Program provides up to $6 million for land, buildings and equipment, financing as much as 90 percent of a project. SBA guarantees 40 percent of the loan, private lenders the rest.

Liquidate some real estate
When it’s tough to borrow, you can raise capital by selling your land or your buildings, leasing them back and using the profits to build more units, a transaction known as a sale-leaseback.

And there are plenty of buyers for restaurant properties, says Joseph French Jr., national director of retail for real estate investment advisors Sperry Van Ness. “There’s more flight than ever to restaurant chain deals, because they’re relatively cheap.”

That’s because commercial property is seen as less risky than residential. In the last quarter of 2007, the default rate for commercial mortgage-backed securities was 0.4 percent, compared with 20 percent for subprime home loans, according to Moody’s.

“We’re dealing with commercial real estate, and you don’t see the same type of impact as you see on home prices,” says Michael Shepardson, managing director of GE Capital Solutions, Franchise Finance. “If you go back to the last big down cycle, in 2000 and 2001, you’ll see restaurant real estate values held pretty steady. They’re wonderful sources of liquidity.”

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