PRIVATE EQUITY: FOCUS ON FRANCHISING - International Franchise Association

PRIVATE EQUITY: FOCUS ON FRANCHISINGBurt YarkinTHE MCLEAN GROUP LLCManaging DirectorPam HendricksonTHE RIVERSIDE COMPANY/ASSOCIATION FOR CORPORATE GROWTHCOO/Vice ChairmanKen BerrymanCapitalSouth Investments & Capital Investment GroupDirector, Louisville OfficeDina Dwyer-OwensTHE DWYER GROUPChairwoman & CEOMike KernLONG JOHN SILVER’SPresident & CEO

THE MCLEAN GROUP, INC.PRIVATE EQUITY &FRANCHISINGBurt Yarkin,Managing DirectorThe 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 andSentinel Capital, etc.)and overall U.S. private equitydry powder of approximately 500 Billion1 Tracking 250-300 private equity firms that haveinvested in franchisors or multi-unit franchisees Segmentation happening with private equity firmsinterested in franchising1. 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 equityOperating control of the business is given to the majority investorUsually some form of leverage (debt) is used in combination with aminority equity investment, primarily to enhance the equity investor’sreturns Minority Recapitalization– Generally a sale of less than 50% of a company’s equity– Proceeds are typically used for partial liquidity events, growth capital, andbuyout of existing shareholders– The owners maintain operating control of the business; the minorityinvestor has certain protections regarding its investment– The company can typically negotiate the contractual right to prepay thedebt and redeem the equity in the future

TYPICAL M&A SELL SIDE PROCESSUnderstandObjectivesPlanning Prepare Determinepreliminary range ofdescriptivematerialsvalue(Confidential UnderstandInformationobjectivesMemorandum) Discuss structural, Develop tailoredlegal & tax issuespositioningand determinestrategy foroptimal approachesstrategic &financial buyers Prepare Buyer ListMarketing Contact potentialbuyers Execute NDAswith interestedparties Solicit IOIsEvaluation& Negotiation Givemanagementpresentations Solicit LOIs Select buyerClosing Coordinatedetailed duediligence Closetransaction

THE RIVERSIDE COMPANYPRIVATE EQUITY: FOCUS ONFRANCHISINGPam HendricksonTHE RIVERSIDECOMPANY/ASSOCIATION FORCORPORATE GROWTHCOO/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 LBOScenario 1: NO DEBTAcquisitionScenario 2: 50% DEBT1/1/2000Acquisition1/1/2000Purchase Price 60,000Purchase Price 60,000Equity 60,000Equity 30,000Debt 30,000Exit1/1/2004DebtExitSelling PriceLess: DebtEquity Returned 01/1/2004 90,000 0 90,000Selling PriceLess: DebtEquity Returned 90,000- 30,000 60,000IRR11%IRR19%CxC1.5xCxC2.0xProfit 30,000Profit 30,000

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 duediligence 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-Englishspeaking 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 systemgrowth

CAPITALSOUTH INVESTMENTSINTRODUCTION TOMEZZANINE FINANCINGKen BerrymanCapitalSouth Investments &Capital Investment GroupDirector, Louisville Office

INTRODUCTION TO MEZZANINE FINANCINGWhat is Mezzanine Capital?Senior Debt 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 throughdetachable warrants and/or equity co-investment More expensive than senior debt and is used whencollateral is limited or owners wish to maximizeleverage of their equity beyond senior debt Patient capital with long-term maturity (4-6 years),interest only payments, balloon at maturityMezzanineEquity

INTRODUCTION TO MEZZANINE FINANCINGComparative Structure and Pricing in the Lower Middle MarketSenior DebtMezzanineEquity 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 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 abilityand 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 FINANCINGUnderwriting Mezzanine Capital Favorable industry characteristicsMature 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

INTRODUCTION TO MEZZANINE FINANCINGPricing Mezzanine CapitalWarrant Deal: RETURN TARGETS (a)35%Cash interest rates will range from 12-14%Warrants to bridge the cash interest rate to theinvestor’s required return of 15-18 %30%25%PIK Deal (no warrant): Payment-in-Kind interest of 2-4% to be paid atthe maturity of the loan as incrementalcompensationA PIK deal will often include an equity coinvestment to achieve upside in the dealEquity Investment: Mezz investors will also invest in equity, either asa standalone investment or alongside zz investors will target returns of 25-30% fortheir equity investmentsMezzanine(cash/PIK)MezzanineLender EquityCapitalSouth will co-invest equity pari-passuwhen its mezzanine qdoesy not feature warrants.Cash InterestPIK Interest(a) Lighter shades represent the range typically featured in CapitalSouth’s transactions for each type of consideration.EquityWarrant

INTRODUCTION TO MEZZANINE FINANCINGUses of Mezzanine Capital Growth: Acquire another business Expand operating locations (PP&E) Provide working capitalMinority Shareholder Buyout: Provide liquidity to exiting shareholder Increase ownership and control for remaining investors Mezz enables greater borrowing capacity and flexibilityManagement 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 FINANCINGWhat Makes Franchised Businesses Attractive Mezzanine Candidates? Rapidly growing niches with attractive unit economics present attractive mezzanine financingcandidates – 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 compellinginvestment 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 supportFranchisees:-Strong unit economics-Attractive existing or high-growth geographic territory-Quality franchisor to provide support

INTRODUCTION TO MEZZANINE FINANCINGHow to Prepare Your Business for Mezzanine Financing Keep complete and accurate financial and operational information to track and explainhistorical 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 industryparticipants, as early as possibleIncorporating these recommendations into your business plan will make your companyattractive to institutional capital sources, and will further both your company’s and your personalfinancial objectives.

THE DWYER GROUP, INC.ANDPRIVATE EQUITYDina Dwyer-Owens, CFEChairwoman & CEOThe Dwyer Group

WHY DID WE SELL?The 1st time1.2.3.4.5.Shareholder valueLow P/E multipleThinly traded stockQuarterly “boxes”Long-term growthThe 2nd time1.Shareholder ROI

WHAT WERE WE LOOKING FOR?1.2.Great deal for all shareholdersCultural fitA.B.3.4.ValuesRespect franchisees/franchisor relationshipPartner that would allow managementto run the businessFinancial resources and brain trust foracquisitions funding

TIMELINEThe 1st timeFebruary 2001SelectedInvestment BankersNovember 2002First RiversideMeetingMay 2003Deal AnnouncedOctober 2003Deal ClosedThe 2nd timeLate 2009Secured BankerDecember 2010Deal Closed

GETTING READY1.2.3.4.5.6.7.Accurate numbersFranchise agreements in orderIdentify obstacles to the saleResolve legal and contractual issuesEstablish conditions related to a saleInfrastructure in placeNote positive trends in the business

DG PRIORITIES1. Check references2. Hire attorney to representmanagement team3. Communication to associatesand franchisees (prospectivetoo)

KEYS TO SUCCESS1.2.3.4.Cultural FitTrue Partnership AttitudeNo surprisesStrive to Live R.I.C.H.

M & A CASE STUDY2011 SALE OF LONG JOHN SILVERSMike KernPresident and CEOLong John Silvers, Inc.

DESCRIPTION Franchisee & Regional Investor Group FR represent 25% system locations; Half FRAdvisory Board Directors; Chairs FRAssociation, and Mktng, Ops, Menu, andBudget Sub Committee’s Non-FR have exceptional restaurant &turnaround credentials Sea change event for brand

KEY EVENT TIMELINE Aug ‘10Sep – Dec ‘10Jan ’11Jan – Apr ’11May – July ’11Jun – Aug ’11Aug ’11Sept ’11Dec ’11Group FormationL.O.I. PreparationYUM Announcement5 Year Business PlanDue DiligenceFinancial ModelingFinal BidBuyer SelectionClosing/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 thedestination 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 legaland finance Build robust pro-forma’s underpinned withfull, current data Stress test & fully understand sensitivities ofmodels

LESSONS . Transition team with full detail task plan iscritical to “zero defects” C.O.C. Talk early and often with brand team toestablish expectations and way forward Change can be an exponentially energizingand empowering event when fullyunderstood and well managed

Sentinel Capital, etc.)and overall U.S. private equity dry powder of approximately 500 Billion 1 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