Though the recent credit hits that plagued the franchise loan sector were localized events - generally not viewed as problems inherent to the sector - investor confidence has slid and liquidity issues are still at stake, market sources said.

Further, with just two deals for $580 so far this year, issuance is well below last year's pace of four deals for $800 million by the end of the second quarter. Still, going forward, particularly for the coming quarter, issuance looks fairly robust, with players like Franchise Finance Corp. of America, Falcon Financial, Amresco and CNL American Properties Fund with deals in the works.

"I think there are issuers who are willing to come to market now though the market's not favorable," said a source familiar with the sector. "But I think that people are holding off as much as they can."

He added that the reason players are hesitant to access the market right now is that there is a lot of negative sentiment from investors.

The Downgrades

Lukewarm investor sentiment towards the franchise loan sector was largely brought about by the recent downgrades from Moody's Investors Service and Fitch IBCA of Franchise Mortgage Acceptance Corp. (FMAC) transactions as well of Global Franchise Trust (GAFco) 1998-1.

The downgrades were associated with credit problems of enterprise loans or business-value loans (see observation on page 21), which are loans secured essentially by the lease of a property, as opposed to a typical real estate loan that is secured by the underlying real estate collateral, such as the land or the building.

With enterprise loans, if a borrower defaults on a lease payment, the lender would have the general right to assume the remainder of the lease term as well as to find another operator of a similar type of business. If a replacement borrower is not found, then the business value ceases to exist, resulting in minimal or no recoveries.

"To say that enterprise loans are problem children is painting with too broad of a brush," said Rupert Chisholm, a vice president at Moody's. "But when we do look at the sort of recoveries of loans that are secured by different types of collateral, we certainly expect higher recoveries as well as less volatility from real estate loans."

But enterprise loans can't be blamed for all of FMAC's woes. A source said FMAC's problems are rooted in the fact that it had more aggressive underwriting standards then the rest of the industry. "FMAC was pretty much a marketing shop and it went after business very aggressively," the source said.

Besides, the risk in enterprise loans could be mitigated by securing a legal interest in the leased property. Aside from this, the business operator can choose a brand that's proven to have good secondary value. For instance, if a business operator chooses a brand that's known only locally, then the brand value wouldn't be worth much. On the other hand, a Burger King, for example, franchise will have good brand value.

A Complicated Asset Type

Though the downgrades are the source of current investor mistrust the franchise sector, in general, is fairly complicated and requires education on the investor's part.

"It's a kind of hybrid between ABS and commercial mortgage-backed securities," said Jon Prestley, a vice president at Hartford Investment Management Co.

Franchise loan deals would often have a short triple-A tranche while the lower-rated tranches have longer maturities compared to other asset-backed securities, he contends.

"There are investors who like it and who have the expertise to analyze it and then you have others who just don't play in it at all," he said.

He added that a lot of times the underlying collateral is very lumpy and many of the pools have large concentrations of similar assets. He also said that since the sector is illiquid, it becomes difficult "when you have a position that you want to trade out of."

Competition on the Rise

"It's a market that got very hot, very quickly," said Ellen Welsher, a director at Standard and Poors Ratings Services. "Several lenders entered in a very condensed period."

The increased competition has limited the number of securitizations in the sector as it has become more difficult for issuers to gain critical-mass to do a securitization.

Also, S&P's Welsher noted that the competition has caused some of the lenders to re-evaluate their underwriting criteria.

New competition is coming from a former allies: the investment banks. Sources say that Lehman Brothers and Morgan Stanley Dean Witter will soon join the ranks of issuers.

The source said that this would not be a good practice for investment banks because there will be a definite conflict of interest. "The banks may be talking about Chinese walls but the reality is if you are competing in the same business that your clients are in, you will be viewed as a competitor and not as someone who is helping them."

He cited the GAFco deal as an example. "It's problematic when an investment bank tries to source the business because Wall Street money tends to be hot money." Though he acknowledged that Lehman has been approaching the business rather conservatively.

"They actually have turned down a lot of business so they haven't been very aggressive about booking business," he added.

Veterans in the franchise loan arena warn against the intrusion of these banks. "Investors should be wary of loans originated by street firms in this fashion where the originators long-term commitment to the franchise-lending sector is questionable. There are exceptions to this as some street firms have strong underwriting criteria as well as deeply committed resources to the sector, which should not deter investors from their paper as long as they also retain carried interests in their securities," said Tom Pearce, founding partner and chief financial officer at Peachtree Franchise Finance. Pearce alluded to an incident where Deutsche Bank and First Boston under a former regime originated loans that were later securitized by FMAC. In that case, the investment banks subsequently left the business.

The Bright Side

Despite the current state of flux in the market, some say the problems have been good for the sector. Whereas before, there was limited differentiation between issuers, people will now be able to distinguish between franchise loan originators.

"Before FMAC's problems, an FMAC's bond would trade fairly closely to an FFCA bond," one source pointed out. "This will give everyone the ability to see the difference in underwriting standards between an FCCA and an FMAC."

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