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6 LESSONS

Corporate : Seven Lessons for a CFO

Prof. Dr. Andre Thibeault 3RF 3R Dr. Dennis Vink © 12

Before the subprime meltdown the In February 2011, Church’s Chicken “The performance of whole -backed had grown to issued secured bonds in the aggre- Bbecome one of the largest capital gate principal amount of $245 backed by restaurant markets in the world in terms of million. The new facility is the franchise payments, such size and volume. The market was first whole-business securitization not only accessed by financial insti- completed in the restaurant sector as the Church’s Chicken tutions, but also by corporates. since 2007. The bonds are backed by , has been «stable,» Corporates increasingly often used the franchise of the nearly note Moody’s securitization techniques to refinance 1,450 franchised Church’s Chicken- Service analysts. These whole lines of by issuing branded and Texas Chicken-branded asset-backed that was rated restaurants in operation both haven’t suff ered during multiple notches above the rating of domestically and internationally and the economic downturn the parent company. One of these substantially all of the tangible and because they experienced instruments that were used is whole- intangible of the approxima- business securitization, also defined tely 230 company-owned Church’s «milder customer traffi c as operating-asset or corporate secu- Chicken-branded restaurants in declines than did the more ritization. 1 The overall issuance has operation in the United States. The expensive fi ne dining and continued in Europe and the United new credit facility is the first whole- casual dining industry States despite the crisis, albeit at business securitization completed in lower levels. 2 An interesting example the restaurant sector since 2007. segments,» of a recent transaction done in the the analysts note. 3 market is that of Church’s Chicken.

1 In one year’s time, both the Dunkin Brands transaction (May 2006) and the Domino’s Pizza deal (April 2007) pushed about $3.5 billion of asset-backed papers onto the market. 2 See report “Recent Developments in Securitization”, published by the European Central in February 2011. 3 http://www.dowjones.de/site/2011/02/churchs-chicken-puts-franchise-fees-on-abs-menu.html. The Financial Executive n°53 • October 2011 7

The decision to use whole-business special purpose vehicle. This defini- securitization involves an explicit tion comprises the fundamentals of choice regarding the financial struc- asset securitization. ture concerned as well as managerial involvement and control. This article Lesson 2: aims to introduce the reader to the The objective is that only the structural features of whole-business investors in the SPV will have securitization by discussing 7 impor- a claim against the securitized tant lessons. assets in the event of the seller’s R.

: not the seller or the © D. First, the general concept of seller’s creditors. Prof. Dr. Andre asset-backed securitization will be Legal concepts in the area of secu- Thibeault discussed. Next, the reader will ritization often differ, and thus have be introduced to the terminology specific and tax rules, Professor of and framework for whole-business secu- including tax consequences for both Academic Director at Vlerick ritization. Finally, an answer will sellers and investors. Common-law Center for be presented to the question how countries (such as Australia, the whole- business securitization distin- and the United guishes itself from more traditional States) for example, follow different areas of corporate finance. legal rules in comparison with civil investors do not have recourse on countries (most other countries). the seller. That makes securitiza- Lesson 1: Despite fundamental differences in tion different than covered bonds, The definition of asset-backed the legal environment, the primary because covered bonds do not allow securitization refers to the issu- objective of the SPV is to facilitate for risk transfer in the same way as ance of tradable debt papers, the securitization of the assets and to securitized products. In the event which are guaranteed based on a ensure that the SPV is established for of , asset-backed securities well-defined collection of assets. bankruptcy purposes as a legal entity have recourse only on the pre-de- Unfortunately, the term ‘asset- separate from the seller. In other fined pool of assets in the SPV, backed securitization’ is used diffe- words, the objective is that only the while covered bonds have recourse rently by many, and the usage is investors in the SPV will have a claim on both the SPV and the seller of not necessarily comparable. Asset- against the securitized assets in the the assets. So one distinct feature backed securitization first appeared event of the seller’s bankruptcy: not from securitized products is the in bank funding. Hess and Smith the seller or the seller’s creditors. liability of the seller in the event of (1988), for example, defined asset- Because the pool of assets is insu- default. Note that covered bonds are backed securitization as a financial lated from the operating risk of the frequently used as an alternative for intermediation process, which seller, the SPV in itself may achieve residential mortgage-backed securi- re-bundles individual principal and better financing terms than the seller ties (RMBS). payments of existing would have received on the basis of to create new securities. More his own merits. This is the key driver Lesson 4: recently, the term ‘asset-backed for reducing financing costs by secu- The element of future exploitation securitization’ has come to be used ritization in comparison with alterna- of the asset is a key distinction to refer to so-called ‘structured tive forms of financing. between standard securitization finance’, the general process by and whole-business securitization. which illiquid assets are pooled, Lesson 3: Whole-business securitization repackaged and sold to investors. So, Asset-backed securities are not uses securitization techniques for asset-backed securitization can best the same as covered bonds. refinancing a whole business or be defined as the process in which The objective of securitization is that operating assets. You may wonder assets are refinanced in the capital the investors in the SPV will have a what exactly is meant by ‘whole market by issuing securities sold to claim against the securitized assets in business’, and where precisely the investors by a bankruptcy-remote the event of the seller’s bankruptcy: difference lies compared with the 8 LESSONS

transactions. Consider for instance of the original owner in order to a mortgage pool. If the mortgages generate revenues. The element of have been securitized, the seller future exploitation of the asset is a (sponsor) has no further obliga- key distinction between standard tions towards the consumer. The securitization and operating-asset mortgage has been closed and stipu- securitization. Control over the lations concerning future payments – flows of the securitized business is to be made by the consumer – have established either through a sale of been laid down in a . Simply the assets, or through an adequate R. R

© D. stated, the financial institution then legal structure that ensures continua- collects payments from the consumer tion of cash flows in the event of the Dr. Dennis Vink for the balance of the life of the insolvency of the borrower. 4 Associate Professor of . In effect, the traditional classes Finance of securitization assets are self-liqui- Lesson 5: Director at Nyenrode Center for Finance dating. By contrast, in the example The receiver has authorization to in which claims on the basis of seize control over the assets of the operating assets are securitized, the securitized business at the loss of sponsor has an obligation to exploit any other creditor. more usual types of used the assets. To offer an In a standard ‘whole-business secu- in securitization transactions: credit illustration: when a football club ritization’ transaction, a financial cards or mortgages, for example. securitizes its revenues from the sale institution grants the sponsor (or In order to make you understand of tickets, the sponsor must continue originator) a loan secured by a pledge whole-business securitization, its to render services that allow foot- on the assets. This is definition will be presented first. ball fans to buy their tickets at the then transferred to a bankruptcy-re- Next, the difference will briefly be box office. Thus, the securitization mote special purpose vehicle, which explained between whole- requires permanent mana- issues the notes. The atta- securitization and the more common gerial involvement on the part ched to the loan is also transferred to forms of securitization, as we know them today: for example the use of mortgages and credit cards. Whole-business securitization can be defined as a form of asset-backed financing in which operating assets are financed in the via a bankruptcy-remote vehicle (hereafter: SPV) and in which the operating company keeps complete control over the assets securitized. In case of default, control is handed over to the security trustee for the benefit of the note holders for the remaining term of financing. One of the great challenges lies in defining the difference between operating asset securitization and the more common forms of securitization

5 This feature makes it difficult in some countries to structure a business securitization deal. In fact, it has been proven to be hard to separate the assets legally while the sponsor still retains operating control and services these assets. Under U.K. law, this difficulty has almost been eliminated by the 1986 Insolvency Act, which permits the holder of a charge over substantially all of the assets of a corporate to control the insolvency proceeds of that corporate through an administrative receiver. The Financial Executive n°53 • October 2011 9 the SPV. Thus, ownership and control privileges of bankruptcy law offering secured debt by the company. This of the assets remain with the sponsor, bondholders extensive security in is the result of the risk mitigation and bondholders are only granted case of default. generated by isolating the assets charge over those assets. Control is from the bankruptcy and other required because the owner of the A clear case of effective recei- of the parent company through the assets should exploit the assets for vership in default is that presented whole-business securitization struc- the full term of financing. Also, the by Welcome Break, the U.K.-based ture. Hence, the holder of an asset- sponsor intends to repay the loan motorway service area operator and backed bond is in a similar out of the cash flows generated from the first whole-business securitiza- to that held by the holder of an ordi- its business. In case of default of the tion operation in its segment. When nary secured bond with regard to sponsor, the SPV receives complete Welcome Break was no longer able the sponsor, because repayment of control over the securitized assets to meet its obligations following its the bonds takes place from a defined by appointing a receiver for the full weaker-than-expected operating pool of assets. The difference is that term of financing. The receiver has performance in 2002, the owner was the holder of an asset-backed bond authorization to seize control over in danger - if the economy conti- is not affected by the non-perfor- the assets of the securitized business nued to slide – of landing in a situa- mance of the sponsor’s other assets, at the loss of any other creditor. This tion in which the company would whereas the ordinary bondholder is. is called bankruptcy remoteness. The not be able to meet its debt obliga- SPV increases the likelihood of the tions. The owner then made an offer Furthermore, structural features in business being able to continue as to the bondholders: Class A’s were whole-business securitization are a going concern rather than being to be repaid at par (£309 million par designed to decrease the moral forced to have a ‘fire sale” of the ), and Class B’s at 55% (£67 hazard of the borrower, and to individual assets. This preserves million par value). The bondholders decrease potential investment the value of the assets securitized, rejected this proposal. Subsequently, conflicts between borrower and which is of great importance to the after Welcome Break failed to make bondholder. In other words, these investors. Whole-business securiti- full payment on its loan, it was features mitigate the risk that the zation therefore efficiently uses the put into receivership. was strength of the business will be appointed administrative receiver. A impaired through mismanagement. few days later, the owner and the Also, the structure is secured by the administrative receiver finally orga- entire set of cash flows generated by nized a solution; the owner agreed the assets, as well as the value of the to pay all classes of bondholders underlying assets. As a result, the back at par by selling nine service structure tends to carry an average stations. lower cost of debt in comparison with ordinary secured debt, thanks Lesson 6: to restrictive covenants on both A whole-business securitization the asset and liability side of the structure tends to carry a lower company. It usually issues debt with average cost of debt compared a longer maturity, which reduces to ordinary debt, and it usually pressure on the corporate issuer to issues debt with a longer matu- place refinancing. rity, which reduces pressure on the corporate issuer to place Lesson 7: refinancing. Post-meltdown whole business The result of bankruptcy remote- securitizations are similar to the ness is that the SPV generally issues whole business deals that were securities that are rated higher (and closed prior to the meltdown, in many cases significantly higher) in but…. comparison with other alternatives, The credit crisis had revealed several such as the issuance of ordinary shortcomings in the securitization 10 LESSONS

structure that includes: lack of trans- to retain some of the junior intensive, are reliant on unique parency regarding collateral, failing in the structure. management skills, or are evolving monoline companies, and rapidly. All of the business securiti- the recognition that financial engi- Conclusions zation transactions executed were neering cannot offset the risk related Whole-business securitization business activities of which the cash to the fundamentals of the opera- enables a business to set up a flows could be accurately estimated tional business . Although we expect structure in which business and thanks to -term and post-meltdown whole business secu- financial risks can be managed and a well-documented history of stable ritizations to be similar to the whole in which the level of cash flows through which the busi- business deals that were closed prior for the can be substan- ness and financial risks were consi- to the meltdown, we expect inves- tially reduced. It could be a good dered low, or could be significantly tors to favor simple and transparent alternative as opposed to a more mitigated by structural features. structures so that investors can now traditional secured loan or collate- scrutinize the product more carefully. ralized mortgage-backed securities Applying such structures, however, Without a doubt less financial engi- (CMBS), because of the limited is not without risks: witness the neering is possible since we know amount of debt capacity available to problems encountered in the now that credit enhancement by companies. Welcome Break transaction. A monoline insurers is not very popular combination of too little return on among investors these days. That Corporate securitizations have investment and too high would probably result in less triple-A primarily focused on the intellectual damaged the sponsor to such an rated tranches in the structure. property arena, including fast food, extent that it was ultimately forced Tranches would reflect their real risk licensing, music, film and drug royal- to make repayments to the investors according to the waterfall ties. But certain kinds of businesses by winding up the business. and subordination levels. Also, origi- are not likely to benefit from a busi- nators are expected to have more ness securitization transaction. These skin in the game that requires them include businesses that are capital