Whole Business Securitizations Lower Borrowing Costs but May Create Conflicts With Managers in Downside Scenarios, Especially in Situations With Company-Owned Stores

The efficacy of whole business securitizations, or WBS, as both a financing vehicle for companies and a structurally enhanced and bankruptcy-remote credit investment has been called into question after the bankruptcy filings of TGI Fridays in November and Hooters in March. Historically used by restaurant and fitness franchisors to create investment-grade-rated debt, resulting in a commensurate low cost of borrowing and suitability to the franchise business model, WBS may not all be fit for purpose, particularly in downside scenarios that give rise to conflicts between investors and the originating parent company in its capacity as manager. These conflicts may be exacerbated when the parent company also owns and operates stores in addition to managing the franchise or brand.

Of the 25 WBS securitizations in our dataset, the average percentage of franchised restaurants (or locations for nonrestaurant businesses such as Lifetime Fitness) in each system at the time of first WBS issuance was 89%. The system mix naturally dictates the underlying collateral in support of the WBS. In systems with lower franchised percentage, operating profits from company-owned stores are typically contributed as collateral to further support the WBS. Of the WBS analyzed, Hooters had the lowest franchised percentage (although this may change post-bankruptcy) at roughly 54% when it issued its Series 2015 notes. For the 12-month period ending the second quarter of 2021, when it issued its Series 2021 notes, EBITDA at its company-operated restaurants accounted for just under half of the securitization’s collections, according to a KBRA report seen by Octus, formerly Reorg, while franchise royalties and fees accounted for only 17%, and royalties from company-operated stores made up the balance. By contrast, in Jimmy John’s Series 2022 WBS, franchise royalties made up 93% of securitization collections, company-owned store royalties 1% and franchise fees 6%. Franchise fees refer to initial upfront payment to the franchisor when opening a location.

Ultimately, a lower franchise mix is typically viewed as credit negative because of the increased exposure to margin pressure and therefore increased cash flow volatility.

Because, in most systems, franchise royalties are structured as a fixed percentage of sales – typically 4% to 6% for domestic U.S. franchises and roughly half that for international locations – WBS often have a systemwide sales trigger for rapid amortization events, whereby if systemwide sales fall below a certain threshold, all collections are diverted to repay principal on the notes before compensating the manager and flowing to equity (which is typically owned by the manager/parent). Below, we show systemwide sales and franchise percentage and detail the underlying collateral for 25 inaugural WBS transactions, ranging from Dunkin’ Brands in 2006 to Subway in 2024.
 

While it may be both legally practicable and economically advantageous to convey the entirety of a company’s rights to franchise royalties and related payments to a bankruptcy-remote entity for the purposes of issuing debt, it does not functionally alter the role of originating parent as manager of the system and brand. It does, however, provide constraints in terms of how the parent performs this role as manager in furtherance of the brand.

Typically, the parent company or franchisor assumes the role as manager under the securitization structure, whereby having sold most or all revenue-generating assets to a special purpose entity, it receives a management fee to conduct training as well as marketing of the brand, supply-chain management and ensuring overall quality control so that the franchisees can operate the system under the brand. Below is the Hooters WBS structure prior to its bankruptcy filing:
 

Hooters’ proposed restructuring under its RSA with creditors would preserve the company’s prepetition WBS structure. However, HOA Funding LLC, the “master issuer” of approximately $307 million of prepetition securitization notes, would be renamed RoyaltyCo and collect a share of royalties and revenue from licenses and franchise agreements, with the remainder to be split with the newly formed brand management company, Brand Management Co., which would replace current manager Hooters of America LLC, or HOA.

Brand Management Co. would enter into a brand management and services agreement with RoyaltyCo to oversee all brand, franchising and management-related functions. This effectively bifurcates the royalty stream between the securitization issuer (in support of the WBS) and the manager (in support of the brand), which we believe should help alleviate conflicts of interest.

For example in the case of TGI Fridays, the parent was removed as manager on Sept. 3, 2024, in part because of the overpayment of a management fee to itself. The ability to remove a manager is a structural protection that features in WBS but may be ineffectual if backup managers are inaccessible or not competent.

S&P Global Ratings described the replacement of the TGI Fridays WBS manager in the following:
 

TGIF had also been improperly withholding sublicensing fees and deferring payment of the 4% royalty on company-owned store sales, according to S&P.

The TGIF securitization structure was already in a rapid amortization period, which began in the second quarter of 2020, after the breach of the $1.5 billion systemwide sales-related trigger, with backup manager FTI Consulting Inc. assuming the role of successor manager, according to a KBRA comment at the time of the removal.

According to its first day declarations, TGIF and the securitization entities entered into a transition services agreement pursuant to which the “Debtors will continue to provide certain corporate and support services for the benefit of the domestic and international franchisees.”

Management fees typically have a fixed-base component and a variable component, which is either based on unit count or a percentage of retained collections. When based on unit count, the per-unit fee for company-owned units is typically twice that of franchised units (because operating expenses are borne by the franchisee), and this is likely why the management fees for Hooters’ and Five Guys’ securitizations, which have the lowest franchised mix in our dataset, are the highest as a percentage of securitized collections, at 28% and 32%, respectively. Manager fees are also typically capped at 35% of collections.
 

Leverage in the WBS structures is typically 4x to 6.6x (5.33x mean) and is measured as debt to securitized net cash flow, or SNCF, calculated as securitized collections less manager fees, servicing fees and securitization operating expenses, which tend to be negligible. Unlike SNCF in non-whole-business securitizations, such as for fiber companies, which is typically smaller than EBITDA because the management fee reflects a capital expenditures component, SNCF in WBS is typically greater than EBITDA, and therefore SNCF leverage may be understated compared with EBITDA leverage. For example, according to Jersey Mike’s series 2024 presale report, adjusted EBITDA was $259 million and EBITDA leverage 6.9x, compared with SNCF of $326 million and SNCF leverage of 5.7x.