Uncertainty, Transparency, and Context: Questions lenders are asking in 2021
Lending to businesses is a constant battle against uncertainty. A loan represents risk. When economic uncertainty rises, lending risk rises. The past 12 months had—and the next 12 months will have—a lot more uncertainty than any period in the past 10 years. And yet, there seem to be a lot of willing franchise lenders out there. How do you explain that?
The answer is not simple, but it is an important one to understand if you expect your brands to continue on (or return to) a growth path. Let’s sort it out by starting with government actions. Banks have just reported Q1 earnings and most are near or making records. Thank a very accommodative Fed with close to an $8 trillion balance sheet of bonds flooding the market with dollars. Yet conventional business loan volume is down considerably over the past 12 months.
Some of the decline is attributable to PPP lending programs that provided hundreds of billions of dollars of cash infusions. For franchising, the temporary increase in SBA 7(a) loan guarantees to 90% also helped. Add to that the stimulus programs and that very accommodative Fed, and the government is creating a lot of lending supply.
Whether it’s debt capital or equity capital, lots of banks and PE firms are out there looking for ways to put this growing amount of capital into productive use. It seems like we should expect banks to be knocking on your door for lending opportunities with your franchisees.
We talk to lenders every day. They have more questions now about franchise brands than at any time since the Great Recession. Their concerns are justified. A franchise system that went through a difficult 2020 has a management team significantly focused on franchisee economic recovery and the changes necessary to stabilize the system for the next 12 to 24 months. How much of their time and attention will they devote to a new franchisee that a bank just made a loan to?
The greatest risk for a new loan is in the first 36 months. Will the economic recovery come quickly enough to that particular sector and territory? What did the franchisor do to help their system through the crisis? Did the franchisor cut staff and reduce support, which could make it more difficult for the bank’s borrower to succeed? How will training and support change going forward? Lots of questions arise that didn’t even occur to lenders 2 years ago.
This isn’t just an issue for sectors hit hard by the pandemic. Sectors such as residential services that for the most part are going gangbusters generate other questions for lenders. What set of assumptions should a lender use to judge a new borrower’s business plan? Lots of consumer and business norms have changed. How do they affect a specific franchise brand, and how sustainable are they?
Many of the questions that lenders are coming to us for in this environment are centered on another key word: transparency. Before lenders commit to a loan that will be outstanding for the next 5 to 10 years, they want to know how strong the brand was going into the crisis, how well it navigated the crisis, and what the next few years are likely to mean for their borrowers. Facing pressure from regulators to not be misleading, franchisors (on the advice of many legal counsels) are inclined to avoid the challenges of trying to explain what the last year looked like inside an FDD. While this issue is exacerbated by the crisis, lenders have long sought another mechanism for transparency. That led to our development of the Brand Credit Report (BCR) years ago, which provides lenders with information not constrained by FDD rules. Based on lender questions and feedback, we are modifying the BCR to address transparency questions arising from the pandemic.
Finally, context is on the mind of lenders. How did a brand adapt, adjust, and perform relative to other brands? Lenders use the FUND scoring model for comparative context because it has a standardized assessment across 12 risk categories. The FUND scoring model will not have significant changes, but may add a feature or two to address lender comparative questions. Many brands will have lower scores this year, but part of what a lender will evaluate is how other brands compared as they all came through the crisis.
If uncertainty is higher, transparency also needs to be higher. While some of that transparency falls within the framework of an FDD, most of what lenders want to know about your brand and sector don’t fit well in an FDD and must be addressed in other ways. Lenders are pushing harder to get to that understanding.
One big takeaway from the recent NAGGL (SBA lender) conference is a warning from the SBA that loan failures from the crisis will start showing up soon. SBA oversight will pressure lenders to be more conservative going forward, which is a predictable cyclical reaction to the crisis. That move to more conservative lending already is showing up in the decline in conventional lending.
As you develop your post-recovery growth plans, make sure you are addressing the three key words capital providers are paying close attention to: uncertainty, transparency, and context.
Darrell Johnson is CEO of FRANdata, an independent research company supplying information and analysis for the franchising sector since 1989. He can be reached at 703-740-4700 or firstname.lastname@example.org.
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