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A work in progress

Securitization financing is wave of future


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Much about securitization remains to be defined, but it can be a good financing mechanism. Here is a look at how two companies, IHOP and Domino's, did it.

This article is a work in process about the technique of securitization. As I write about this month’s topic, there are significant, pending transactions using the franchisor’s cash flow and royalty streams as a collateral source for low interest debt financing, which may further define this topic.

There has been a great deal of publicity around this topic and some of the major transactions—particularly the Domino’s transaction and more recently the Dunkin’ Brands transaction.


Dennis L. Monroe is a partner and the chairman of Krass Monroe, P.A., a law firm specializing in multi-unit franchise finance, mergers and acquisitions, and taxation.
Dennis can be reached at (952) 885-5999

 

The primary way these types of transactions are structured is through the use of special purpose entities (SPE’s) to hold the assets that generate the cash flow of the franchisor (either royalty streams or other sources of cash flow). This segregate cash flow is the key element for the sale of the bonds. Along with an insured element, it provides the needed security for the bondholders.

I recently had the opportunity to interview both Tom Conforti, the Chief Financial Officer of IHOP Corp., and Kate Lavelle, the Chief Financial Officer of Dunkin’ Brands, Inc. Both of these companies were involved in major securitized transactions.

As we know, IHOP management has done a wonderful job of growing the company, and its stock is performing well. In an effort to secure financing (for the buy-back of their stock or for a potential acquisition), IHOP recently entered into a successful securitization. IHOP’s securitization was unique because it was based on the company’s entire cash flow, not just royalty streams. Every conceivable cash payment was the source of cash flow for the IHOP securitization.

Even though certain issues came up in IHOP’s securitization (particularly the quality of cash flow from some of the components of IHOP’s business), IHOP was able to package all of this together and place all of its cash flow into an SPE.

IHOP’s transaction is unique because it did not go with an overly leveraged transaction. It could have received additional proceeds from the securitization—something approximating seven times cash flow—but instead elected to go with 4.7 times. This, in turn, allowed IHOP to get wonderful performance of the bond sales. IHOP was able to sell the securitization as investment-grade AAA paper. Also, by not trying to push the envelope, IHOP’s insurance costs related to the obligation’s insured factor were very reasonable.

At Dunkin’ Brands, Kate Lavelle provided me with significant insight into her company’s securitization. Company owners used securitization as an acquisition-funding vehicle. Dunkin’ Brands consists of three different concepts, necessitating a different approach than the IHOP transaction. Additionally, the Dunkin’ Brands securitization was a highly leveraged transaction and had a specific purpose. Much like IHOP, Dunkin’ Brands securitized all of its cash flow. It used different special purposes entities for each brand and for its real estate. These special purpose entities all came under one umbrella. This umbrella entity was used to issue the bonds based upon the cash flow. Like IHOP, Dunkin’ Brands was able to get tremendous performance. It was able to raise $1.5 billion as AAA rated bonds and $100,000 through the issuance of uninsured subordinate notes.

The insurance products accompanying the high-grade bonds will provide ultimate protection to investors. Further, the insurers are only willing to provide appropriate insurance at an AAA level if the company is solid and clearly able to perform the repayment process.

One big issue is the compliance process. Lavelle said that, in the beginning, the weekly compliance was a challenge, but by the time of the first monthly reports, the company was able to work through this process effectively. It is now in the process of going online with an automated compliance process.

Both Conforti and Lavelle stressed that their company’s securitizations allowed for advances of additional funding in the future and provided a significant amount of flexibility at a very attractive rate, which made the legal and investment banking process worth the cost. With this type of resounding support, it is clear the securitization process is here to stay and will be utilized by many other franchisors.

Please keep in mind the following thoughts about securitization:

• The securitization and repayment of the bonds are all administered through a master trust arrangement. The trustee takes charge of all of the cash flow coming in. There is a disbursement account so the borrower (for example, IHOP) can service all of its ordinary operating obligations and then the current obligations under the bonds. This seems onerous but, in most cases, this is fully automated and rather seamless to the borrower.

• There are other key components to securitization, such as the purchase of swap obligations and other types of capital instruments engineering, which can be complicated. But again, the key to effective securitization is not pushing the envelope, getting good performance by not having an over-leveraged situation, having strong technology and, finally, to really do effective internal auditing so the transaction anticipates the issues that may come up and addresses those concerns.

Other franchisors are now in the process of proceeding with securitizations. Securitization is a complicated transaction and requires significant financial engineering and legal expense. However, it does seem to be the way of the future for the franchisor. We have yet to see securitization evolve back to the franchisee’s side, but we do know the franchisors are going to significantly utilize securitization in the near term.

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