Financing a Transaction: What the Higher Cost of Capital Means for Getting a Deal Done in 2024
Ryan Palmer: Good afternoon. It's the last one of the day. Welcome to this panel on financing a transaction: what the higher cost of capital means for getting a deal done in 2024.
My name is Ryan Palmer. I'm a partner at the law firm GPM, and I run franchise and restaurant deals for the firm. It's my pleasure to lead this panel through what I think will be a very spirited conversation about what deals will look like in the months to come and what we've come through so far.
So we've got Brett Bishov, the Managing Partner at Capital Insight.
Brett Bishov: I started a lending business that was acquired by Wells Fargo — it's Wells Fargo Restaurant Finance today — and shortly thereafter I started Capital Insight. I've done about $15 billion of M&A and corporate finance as an advisor and principal in the multi-unit retail space, much of it in the restaurant industry.
Ryan Palmer: Brett, with just an overview of what we've come through in 2023 — we've heard it was a slow start to the year, with some possible momentum going into year-end and into the first quarter. What are you seeing? What kind of deals are getting done right now, generally?
Brett Bishov: Multiples and valuations are still semi-embedded in expectations, with interest rates and credit tightening pushing M&A down materially. In the restaurant space, you've seen a ton of statistics, but 80% of the deals getting done are off-the-run independent chains and franchise deals, where expectations are aligned on multiples, and operators are more well-capitalized and less dependent on leverage. So deals are still getting done. We have three sell-side M&A deals closing between now and year-end, and the valuations were reasonable, but the buyers and sponsors are committing a little more incremental capital because they find it strategic and desirable. So I think it's a moderation of expectations, and things will improve next year — still relatively slow, but it will definitely improve, in my opinion.
Ryan Palmer: Brett, I imagine you have views on valuations there.
Brett Bishov: They haven't come down yet on the deals that are getting done, but in the paradigm of negotiating and discussing expectations, there is dialogue about some compression. It certainly isn't tracking the relative increase in interest rates on a directly linear basis to multiples.
Interest rates have effectively doubled. That doesn't mean multiples are going to come down 50% — but there is some compression, and the reality is: if somebody doesn't have to sell, they don't have to sell.
But if you want to be realistic about getting into the market, you have to start calibrating for the leverage lines, because it's not just interest rates. There's more conservative underwriting — unless you're a modestly leveraged, large operator with a national brand, you're going to get less favorable covenants, less liquidity and lower leverage.
So it's going to calibrate, similar to what Glenn was describing with non-real-estate cap rates — cap rates always lag interest rate increases, and invariably they come up. There is credit tightening happening, and that credit tightening is going to result in some multiple compression. It may not be dramatic, but it exists.
Ryan Palmer: Got it. Brett, what do you tell your clients when they want to get something done?
They're used to doing deals from 2019 — a very different environment — and they come to you now. What do you tell them about structure, what they have to bring to the table, and where you see the resilience?
Brett Bishov: First of all, the strategic, well-capitalized buyer has a huge advantage in this market, because the alignment of interests on valuation, when there are synergies from a larger consolidator, is beneficial.
But what I'm guiding people toward is having realistic expectations — if all things being equal, and you're not going to be flexible on valuation, you're going to have to be flexible on proceeds, carrying paper, or deferred purchase price.
As I said, we have three deals closing between now and year-end, and there are earn-out structures and other things built into those deals.
Try not to over-engineer a deal — any time you over-engineer a deal, it becomes a headache for everybody, or it stalls.
The power of "no" is pretty interesting. If you want certainty, or at least more visibility, give it a few quarters and let the market settle and stabilize. Creating false deadlines in a disrupted market is counterproductive.
Ryan Palmer: I'm not asking you to spill any secrets about the deals you have closing, but in a general sense, what do you see in terms of earn-outs and seller notes, and in terms of percentage of purchase price — how much higher are we than your old deal norms?
Brett Bishov: Five or ten percent more. And what I've also been doing with buyers is managing expectations upfront, telling them that we're not going to take capital markets risk. So if you're not equipped to contribute a minimum of, say, 50 or 60 percent of the deal — whatever the number is — we need to know that.
We're always reverse-engineering the motives and the risks of a deal by looking at the incentives of the buyer. We always underwrite what we believe a buyer's return profile looks like, because it's a litmus test. You have to run a sanity check — somebody puts in an LOI, says their leverage is X and their equity is Y, and you run an equity return model and their IRRs come out at 13%. You have to ask yourself: are they really going to close, and if they are, what do they know that we don't? So we look at both sides, because if you don't understand the motives on either side, you're not really qualified to advise either side. You've got to know both.
When you think about it, so much leverage was put out in '21 and '22 that you're going to start seeing refinancing risk. The amount of swaps and hedge positions in place today that come into the money over the next two years — starting at 12 months out to 36 or 48 months — there's a ton of refinancing risk for leveraged, even modestly leveraged, operators when they go out to recap or refinance; they're going to have some pretty meaningful struggles.
I've been telling clients that they've got to wait for that window, because those sellers who didn't sell, or didn't want to sell, when they're facing a sale or refinancing, there are going to be some decisions to be made, and there will be some fallout.
Ryan Palmer: Let's talk about that in terms of M&A. If you're on the sell side and you're looking at a buyer, what are you doing to verify the buyer is real? What are you doing to make sure this is actually a deal, and that they can get done what they think they can get done?
Brett Bishov: As I said earlier, we reverse-engineer the economics — for a seller, we look at it from the buyer's perspective, and for a buyer, from the seller's perspective. Because if the economics don't make sense, you have to size what the capital structure would rationally look like to gauge probability and underlying motivations. We're not asking buyers to provide proof of funds per se, if they have credibility. But if their expectations are to borrow an unrealistic amount of money, forget it — we're not even going to waste our time.
So if their capital structure makes sense, if the returns make sense, and they have the right incentives to execute — like the few deals we're working on to close this year — those have met the hurdles, and it's just a little more diligence before you sign a purchase agreement.
Ryan Palmer: Brett, where do you fall on what 2024 looks like?
Brett Bishov: I think, as I just said, deal with what you know. One of the challenges I've always focused on is taking emotion out of it and not coming in with a preconceived idea.
The market's efficient. If you hire someone who's competent and knows what they're doing, and you go to market with modest, guardedly optimistic expectations — if you know what you're doing and present it the right way, you'll figure out where a business can trade. Every entrepreneur is optimistic, God bless them, especially in the restaurant space. Be realistic, present the best possible case, and take emotion out of it if you can. If you want to execute, be prepared, as Patty said, without a doubt — put your best foot forward and let the market dictate.
I think there'll be opportunity.
Ryan Palmer: We can wrap it up there. Thanks very much, everybody, and my thanks to you guys — you've spent a lot of time. Really appreciate it.