PRIVATE EQUITY: FOCUS ON FRANCHISING Burt Yarkin THE MCLEAN GROUP LLC Managing Director Pam Hendrickson THE RIVERSIDE COMPANY/ASSOCIATION FOR CORPORATE GROWTH COO/Vice Chairman Ken Berryman CapitalSouth Investments & Capital Investment Group Director, Louisville Office Dina Dwyer-Owens THE DWYER GROUP Chairwoman & CEO Mike Kern LONG JOHN SILVER’S President & CEO

THE MCLEAN GROUP, INC. PRIVATE EQUITY & FRANCHISING

Burt Yarkin, Managing Director The McLean Group

PRIVATE EQUITY AND FRANCHISING

• Private Equity is playing a larger role in franchising

PRIVATE EQUITY TRENDS

• Strong level of interest based on previous success (Roark Capital, Levine Leichtman, Riverside and Sentinel Capital, etc..)and overall U.S. private equity dry powder of approximately$500 Billion1

• Tracking 250-300 private equity firms that have

invested in franchisors or multi-unit franchisees

• Segmentation happening with private equity firms interested in franchising

1. PItchBook 2013 Annual Private Equity Breakdown. Seattle, WA: PitchBook Data and MERRILL DATASITE, 2013. Print

COMMON TYPES OF M&A TRANSACTIONS

• Full Buyouts

• Majority Recapitalization • Sale of 51% or more of a company’s equity • Operating control of the business is given to the majority investor • Usually some form of leverage (debt) is used in combination with a

minority equity investment, primarily to enhance the equity investor’s returns

• Minority Recapitalization – Generally a sale of less than 50% of a company’s equity – Proceeds are typically used for partial liquidity events, growth capital, and

buyout of existing shareholders – The owners maintain operating control of the business; the minority

investor has certain protections regarding its investment – The company can typically negotiate the contractual right to prepay the

debt and redeem the equity in the future

TYPICAL M&A SELL SIDE PROCESS

Planning Understand Objectives Marketing Evaluation

& Negotiation Closing

Determine preliminary range of value

Understand objectives

Discuss structural, legal & tax issues and determine optimal approaches

Prepare descriptive materials (Confidential Information Memorandum)

Develop tailored positioning strategy for strategic & financial buyers

Prepare Buyer List

Contact potential buyers

Execute NDAs with interested parties

Solicit IOIs

Give management presentations

Solicit LOIs Select buyer

Coordinate detailed due diligence

Close transaction

THE RIVERSIDE COMPANY PRIVATE EQUITY: FOCUS ON FRANCHISING

Pam Hendrickson THE RIVERSIDE COMPANY/ASSOCIATION FOR CORPORATE GROWTH COO/Vice Chairman

OUTLINE

• LBOs 101

• Why do PE firms like franchise businesses?

• What challenges do franchises pose for PE?

• Things PE firms like to see…

• Things PE firms don’t like to see…

EXAMPLE OF AN LBO

Acquisition 1/1/2000

Purchase Price $60,000

Equity $60,000

Debt $0

Exit 1/1/2004

Selling Price $90,000

Less: Debt $0

Equity Returned $90,000

IRR 11%

CxC 1.5x

Profit $30,000

Acquisition 1/1/2000

Purchase Price $60,000

Equity $30,000

Debt $30,000

Exit 1/1/2004

Selling Price $90,000

Less: Debt -$30,000

Equity Returned $60,000

IRR 19%

CxC 2.0x

Profit $30,000

Scenario 1: NO DEBT Scenario 2: 50% DEBT

FRANCHISES ARE GOOD FOR PRIVATE EQUITY

• Mature franchisors have robust recurring revenue streams

• Proven business model

• Less operationally intensive/easier to manage

• Customer concentration is rare

• Revenue stream and expenses are straightforward, making due

diligence easier

FRANCHISE CHALLENGES IN PRIVATE EQUITY

• The relationship with the franchisees

• Lack of critical mass often means there is not much infrastructure,

so information can be a challenge

• Hard to tell if underlying franchisees are making money

• Important to understand franchise law

• Managing the brand

DUE DILIGENCE

• Growing recurring revenue stream

• Profitable underlying franchisees

• Good back office systems/technology

• Payback of less than 3 years

• Is franchisor truly creating value for franchisees

• Ability to charge a 2% marketing fee for national advertising

• Company store operation that proves business model

DUE DILIGENCE

• Franchisee litigation/negative comments from franchisees

• Active & aggressive franchise association

• Franchise system which has sold off major territories

• Growth predicated on international expansion in non-English

speaking countries

• A revenue earning stream driven by spikes in new license sales vs.

recurring revenue stream

• Market not big enough to support double digit to live system

growth

CAPITALSOUTH INVESTMENTS INTRODUCTION TO MEZZANINE FINANCING

Ken Berryman CapitalSouth Investments & Capital Investment Group Director, Louisville Office

INTRODUCTION TO MEZZANINE FINANCING

• Layer of capital between senior debt and equity, usually referred to as subordinated debt

• Transitional capital to facilitate buyouts, recapitalizations, acquisitions or internal growth

• Usually has upside equity exposure through detachable warrants and/or equity co-investment

• More expensive than senior debt and is used when collateral is limited or owners wish to maximize leverage of their equity beyond senior debt

• Patient capital with long-term maturity (4-6 years), interest only payments, balloon at maturity

Equity

Senior Debt

Mezzanine

What is Mezzanine Capital?

INTRODUCTION TO MEZZANINE FINANCING

Equity

Senior Debt

• Currently priced with cash interest between 6-9%

• Debt typically secured by a first lien on all of the borrower’s assets

• Usually amortizes over a period of 3-7 years

• Principal is limited to a percentage of borrower’s available collateral

Mezzanine

Comparative Structure and Pricing in the Lower Middle Market

• Currently priced to yield 14-18% percent

• Subordinate to the senior lender, usually under-collateralized

• Typically interest-only, no amortization

• Borrower limited to borrowing based on cash flow generating ability and fixed charge coverage

• Much more expensive than mezzanine: required returns of 25-30%

• Fully subordinate in right and payment to all debt

• Return to capital providers dependent on residual value

• Greater equity contributions suppress total returns

INTRODUCTION TO MEZZANINE FINANCING

• Favorable industry characteristics

• Mature businesses with strong and sustainable historical cash flows with good margins (i.e., 10%+ EBITDA margins)

• Limited customer concentration

• Deep and experienced management team with meaningful personal investment

• Subordinated debt-to-EBITDA ratio 0.5x – 2.0x; Total leverage of 2.5x – 4.25x

• Fixed charge coverage ratio greater than 1.15x EBITDA

Underwriting Mezzanine Capital

INTRODUCTION TO MEZZANINE FINANCING

0%

5%

10%

15%

20%

25%

30%

35%

Mezzanine (cash/warrant)

Mezzanine (cash/PIK)

Mezzanine Lender Equity

q y

Cash Interest PIK Interest Equity Warrant

Pricing Mezzanine Capital

Warrant Deal:

• Cash interest rates will range from 12-14%

• Warrants to bridge the cash interest rate to the investor’s required return of 15-18+%

PIK Deal (no warrant):

• Payment-in-Kind interest of 2-4% to be paid at the maturity of the loan as incremental compensation

• A PIK deal will often include an equity co-investment to achieve upside in the deal

Equity Investment:

• Mezz investors will also invest in equity, either as a standalone investment or alongside the mezzanine

• Mezz investors will target returns of 25-30% for their equity investments

CapitalSouth will co-invest equity pari-passu

when its mezzanine does not feature warrants.

RETURN TARGETS (a)

(a) Lighter shades represent the range typically featured in CapitalSouth’s transactions for each type of consideration.

INTRODUCTION TO MEZZANINE FINANCING Uses of Mezzanine Capital

• Growth:

Acquire another business

Expand operating locations (PP&E)

Provide working capital

• Minority Shareholder Buyout:

Provide liquidity to exiting shareholder

Increase ownership and control for remaining investors

Mezz enables greater borrowing capacity and flexibility

• Management Buyout:

Support existing management teams seeking to buyout principal owner(s)

Leverage existing managers’ personal capital for a significant ownership stake

Managers continue to manage the business and strategic direction

INTRODUCTION TO MEZZANINE FINANCING What Makes Franchised Businesses Attractive Mezzanine Candidates?

• Rapidly growing niches with attractive unit economics present attractive mezzanine financing candidates – especially with respect to the equity portion of the mezzanine lender’s investment.

• On the other hand, mature industry segments with strong cash flows present compelling investment opportunities – especially with respect to the prospective borrower’s credit quality.

• Franchisors and franchisees are equally compelling investments:

Franchisors:

- Healthy franchisee base

- Established or high-growth brands

- Quality marketing plan, menu management and operational support

Franchisees:

- Strong unit economics

- Attractive existing or high-growth geographic territory

- Quality franchisor to provide support

INTRODUCTION TO MEZZANINE FINANCING How to Prepare Your Business for Mezzanine Financing

• Keep complete and accurate financial and operational information to track and explain historical performance.

• Build a complete and experienced executive management team.

• Prepare a strategic plan and 5-year financial forecast, and keep it updated.

• Approve an annual budget and explain any deviations in a written MD&A.

• Structure and maintain a diverse and productive board of directors.

• Get familiar with the different sources of junior capital and get to know many industry participants, as early as possible

Incorporating these recommendations into your business plan will make your company attractive to institutional capital sources, and will further both your company’s and your personal financial objectives.

THE DWYER GROUP, INC. AND

PRIVATE EQUITY

Dina Dwyer-Owens, CFE Chairwoman & CEO The Dwyer Group

WHY DID WE SELL?

The 1st time 1. Shareholder value 2. Low P/E multiple 3. Thinly traded stock 4. Quarterly “boxes” 5. Long-term growth

The 2nd time 1. Shareholder ROI

WHAT WERE WE LOOKING FOR?

1. Great deal for all shareholders 2. Cultural fit

A. Values B. Respect franchisees/franchisor relationship

3. Partner that would allow management to run the business

4. Financial resources and brain trust for acquisitions funding

TIMELINE

The 1st time February 2001 Selected

Investment Bankers November 2002 First Riverside

Meeting May 2003 Deal Announced October 2003 Deal Closed

The 2nd time Late 2009 Secured Banker December 2010 Deal Closed

1. Accurate numbers 2. Franchise agreements in order 3. Identify obstacles to the sale 4. Resolve legal and contractual issues 5. Establish conditions related to a sale 6. Infrastructure in place 7. Note positive trends in the business

GETTING READY

DG PRIORITIES

1. Check references 2. Hire attorney to represent

management team 3. Communication to associates

and franchisees (prospective too)

KEYS TO SUCCESS

1. Cultural Fit 2. True Partnership Attitude 3. No surprises 4. Strive to Live R.I.C.H.

M & A CASE STUDY 2011 SALE OF LONG JOHN SILVERS

Mike Kern President and CEO Long John Silvers, Inc.

DESCRIPTION

• Franchisee & Regional Investor Group • FR represent 25% system locations; Half FR

Advisory Board Directors; Chairs FR Association, and Mktng, Ops, Menu, and Budget Sub Committee’s

• Non-FR have exceptional restaurant & turnaround credentials

• Sea change event for brand

KEY EVENT TIMELINE

• Aug ‘10 Group Formation • Sep – Dec ‘10 L.O.I. Preparation • Jan ’11 YUM Announcement • Jan – Apr ’11 5 Year Business Plan • May – July ’11 Due Diligence • Jun – Aug ’11 Financial Modeling • Aug ’11 Final Bid • Sept ’11 Buyer Selection • Dec ’11 Closing/C.O.C.

LESSONS……

• Get the right people on the bus* • Make sure they’re in the right seats* • Create a very detailed map to the

destination • Add talented resources along the way • Explore continually while on the journey

* Jim Collins, “GOOD TO GREAT”

LESSONS…..

• Have a complete, long term business plan • Retain very good outside advisors in legal

and finance • Build robust pro-forma’s underpinned with

full, current data • Stress test & fully understand sensitivities of

models

LESSONS….

• Transition team with full detail task plan is critical to “zero defects” C.O.C.

• Talk early and often with brand team to establish expectations and way forward

• Change can be an exponentially energizing and empowering event when fully understood and well managed