Private Equity's Unique Subway Sandwich!

Welcome, welcome, welcome to The Deal Room. This is my debut. This isn't Anthony. If you're not watching on YouTube, Piers Curran here, stepping in for Anthony Cheung to join Stephen, uh, to chat all things M&A. Uh, so welcome to the latest episode. Hi Stephen, how's it going?

Yeah, pretty well. Good to, uh, good to see you, Piers. I was just discussing, we've just dated our, our speech. And I've got the newest version of the Amplify t-shirt, which I'm quite proud of. I've actually been wearing it every day this week. And you've got the old one. What's going on there?

Well, you know, as I said, I like to go retro every now and then. I've actually got— I think I'm the only owner of the original Amplify t-shirt, which dates back over a decade. I'm pretty sure not even Will has one of those. So As collectible items go, that's right up there, I would say, valuable.

Yeah, yeah, I think that's a good asset that we could probably borrow against in the future. We can probably talk about that a little bit later on.

Yes, indeed. But look, let's talk— let me, um, let me lay out the sort of, well, kind of 3 broad talking points for today. Um, so we're going to talk Well, JD, uh, this is a Chinese, you know, monster conglomerate, and well, they've decided to split up, split up into 7 different parts. It kind of suspiciously in some ways comes on the, on the coattails of Alibaba, um, announcing pretty much the exact same thing a few days prior where they're looking to break up into 6, uh, parts. So yeah, we're going to talk about, you know, I guess, unlocking value through spinouts. But, you know, thinking about the logic of conglomerates and, and this thing called verticalization, and then the logic of breakups and spinouts, and does it make sense? Um, so we'll, we'll discuss and tackle that. Number 2, uh, we're going to go UK mobile phone networks. You might have heard in the news that Vodafone is looking to merge with the with Three. Three is actually owned by a company called CK Hutchison, Hong Kong-based company actually. But look, these two are looking to merge. The issue is this will create, well, the world's— sorry, the world's— the UK's biggest mobile network. If they did merge, I think they'd have 28 million customers. So yeah, I would love your thoughts, Stephen, on what this means from the regulators and the Competition Commission's point of view. And, you know, really what size market, what size market share is appropriate? And what, you know, is it a good thing for the UK mobile phone network that we get such a giant player or not? And will it get through the regulator's scrutiny or not? And then finally, we're going to chomp into a bit of Subway and you know, talk, uh, buyouts because we've got certain suitors, uh, weighing up— I think it's a $3 billion securitization, um, sort of buyout fund. So we're going to talk about that and really delve into things like capital structure and use this as a sort of case study to, you know, talk about leverage financing and so on. So there are kind of 3 big topics, but yeah, let's talk Let's talk JD. And before you wade into it, there's a thing called 618, which is a Chinese shopping day. You might have heard of Singles' Day, which is the number one retail event of the year in China. Singles' Day, I think, is that in November? Correct me if I'm wrong. Am I right in saying it's in November? I'm not sure.

You're right, yeah. I think it is.

And this is the day where, yeah, comfortably the, the largest amount of, um, money gets spent on online shopping. Just behind that in terms of, um, biggest shopping days of the year is this 618 day. It's the 18th of June, and again, it's used as this kind of monster kind of marketing excuse, uh, for the e-commerce giants to, um, run campaigns and try and drive traffic to their sites and get people snapping up bargains and kind of stuff like this. It's a bit genius, I have to say, because JD, um, are behind this 618 thing phenomenon. It's actually their anniversary as a company. They were founded in 1998 by this guy called Liu Guangdong, and they were founded June 18th, 1998. And, um, they managed to kind of basically use their birthday as an excuse to flog a load of stuff at cut-down pricing. And it kind of gathered momentum to the point where all other retailers then jumped on the bandwagon and it's just exploded to become this kind of massive sort of national annual event. But, um, but yeah, so JD are kind of behind that big event, which was of course earlier this week. So they've used this anniversary, um, to also make a big announcement. Um, so what are they up to? They're going to break up? What's going on? No, no, good.

Uh, I didn't know that about the, uh, the the 618. So that's really interesting. It reminds me of the, of the invention of Valentine's Day. Uh, I'm not sure if it's apocryphal, but you know, the marketing executives in 1950s America thinking we need to generate some cash between Christmas, that dead spot between Christmas and Easter, right? Let's, let's create something. So pretty genius, as you said. But this is, yeah, this is, I love this story because it's, you know, it's a story of conglomerates. And it's also a story that links back to if you did economics at A-level or, you know, even at university, this is all about economies of scale and it's all about specialization and focus and all of these really interesting business principles. So, you know, a little bit of background on what a conglomerate is and kind of some examples of pretty famous conglomerates. So conglomerate is essentially a holding company, a company that sits above a number of different subsidiaries that are either wholly or partially owned by the holding company, that can exist in almost every different or any different industry. So the traditional old-school conglomerate, my favourite example is, you know, the Hong Kong conglomerate Swire and Jardines. So Swire, it's an old-school conglomerate that sits atop Cathay Pacific, which is an airline, Swire Properties, which is a property company. They own a shipping division, they own, um, car park forecourts and, and, um, car sales distributors. You know, what is the rationale between this diverse mix, this hodgepodge of different industries? You'd even say Berkshire Hathaway is a bit of a conglomerate in that sense, right? The reason why you would find conglomerates potentially quite attractive as a kind of holding company— I found two reasons. Firstly, you can access the capital at a cheaper price because you're a bigger entity, and therefore you can borrow cheaply and distribute down to any part of that holding company that you wish. Obviously there are, there are potential issues with where you put that money, but you have these economies of scale, you know, in terms of the cash flow going up to the holding company. The second is diversification. If Cathay Pacific's not doing well one year, then maybe it will get counterbalanced by Swire Properties doing very well the next year. So you've got this kind of portfolio element as an owner, as a holding company, it's quite attractive. So to bring it forward to JD.com, yeah, it's exactly the same story with Alibaba. You start off with a really nice kernel of a business, the e-commerce business, right? And then, you know, as you grow, as you get more excited about scale, as you, as you recognize different areas of opportunity in different adjacent business areas, you start thinking, well, you know, I've done this job pretty well. Why don't I just start a business here? You know, why don't I just start a logistics business? Why don't I just start a health business? Why don't I just start a property business? Why don't I just start an industrial business? You know, and these are all businesses that JD.com has started. But there comes a point where sound business sense You know, if I'm an e-commerce company, maybe it makes a lot of sense to own a logistics company because I'm owning a different chunk of the supply chain and taking margin. But does it really make sense to own an industrials company? You know, is that too adjacent to be core to the business model and also the pitch that you make to investors as they're looking to invest in you? And obviously increase the share price. So JD.com and Alibaba have basically become kind of slightly ugly monsters in, in the sense that they've got these sprawling business units employing hundreds of thousands, actually over a million people, and there's not necessarily a lot of logic to some of these business units. And Piers, you'll know this really well, if I'm an investor I've probably got a remit or a mandate or a sector or a theme that I'm looking at, right? You know, with, you know, a company needs to have minimum percentage revenues in X area in order for me to kind of include it in my universe. These big conglomerates start looking a little bit unwieldy and they start falling out of buckets instead of into buckets. Yeah. Furthermore, what happens, you know, this happens across startups and big businesses. What happens when you're basically running 7 businesses? You lose focus. So what's happened with JD.com and Alibaba— we might counterpoint this to Amazon in a separate discussion— what's happened with JD.com and Alibaba is, you know, due to macro events but also due to internal business model, their share prices have absolutely fallen off, down 60-70% since highs in 2021. Now again, that's partly macro, but that is partly because investors are trying to figure out where growth is coming from. So when JD announced that it is spinning its business into 7 different business units, all majority owned by the holding company— so this isn't them getting rid of the family silver, this is them creating these individual, nimbler, leaner business units that can go out, you know, IPO, raise separate funds, you know, be hungry and take market share in those businesses. When they announced that they were splitting and spinning off, you know, getting rid of maybe the diseconomies of scale that they were seeing, JD.com share price popped by 7%. Alibaba's, when they announced it, it actually popped by 14%. So investors are kind of breathing a sigh of relief and going, suddenly you're doing something that makes sense and potentially unlocking a lot of value because these are good businesses just in a relatively unwieldy structure.

Okay, so I— okay, so like when you see a headline like Alibaba or JD are breaking up into 7 entities, okay, when you get under the skin of it, and that's not actually— so if the holding company maintains majority ownership of the new 7 entities. And I guess it's the best of both worlds in so much as they're retaining those— some of those economies of scale elements, not just from a, I guess, a— well, I don't know, a financing point of view. Would each of the 7 entities now go out and raise funds individually?

Maybe they would, maybe they wouldn't.

But I guess that there are other economies of scale factors like, you know, you can have centralized functions, right? And so I assume they can retain, you know, functions like, I don't know, HR or finance or whatever. And maybe they can retain all the good stuff on the economies of scale, but then they won't suffer from— yeah, they kind of fall out of these sector buckets because they're too unwieldy, as you said. So yeah, I guess, I guess, I guess makes sense. So what I'm— well, I got two questions, I guess. Number one is, well, why now? And I'm a bit suspicious. Why is it like literally within sort of 3 days of each other Alibaba and JD have made pretty much the exact same announcement? So, so what is it about June 2023 that has suddenly triggered both to pull the trigger on this?

Yeah, it's a really interesting question and it's one that I'm certainly not an expert on, but there's definitely a macro element to this. Yeah. You know, so over the last few months, China, which has been shunning tech and kind of closing its door to these big, you know, slightly maybe too, too big to control tech companies within the country, it started to kind of reopen the door and to invite Jack Ma back from wherever he was staying and starting to be a bit more business friendly. Right. And I think probably, quo pro, you know, one can speculate that the reason why the door was shut on the likes of Jack Ma was because there was a concern that he was becoming bigger than the state and a bit of a statesman-like figure. You know, if he comes back and says, not necessarily groveling, but saying, look, actually, would bring you more favor if we created a slightly more decentralized structure with individual CEOs and individual boards of directors IPOing with their separate entity, would this make you feel more comfortable? And would this make you feel more inclined towards supporting e-commerce and tech businesses? You know, that is a pretty compelling argument to the Chinese government. So, you know, maybe there's a macro element to this. I'm sure there's a lot of investor pressure. A lot of people bought into JD.com and Alibaba, you know, a few years ago, uh, and, you know, it's listed in the US, you know, it's dual listed. So, you know, US investors are thinking, where's my 70% gone? Um, you know, it used to be trading at X, now it's 70% off. There's going to be investor pressure, hence why you saw both stocks jumping on the announcement. It just seems like good news. Yeah, if and only if— well, it can be done successfully.

Well, that's it. I mean, it sounds good on paper and share prices pop, but I mean, what are the risks? I'm sure there's some pitfalls along the way here in terms of execution.

Yeah, it's really interesting. So we talk in the world of M&A about synergies, right? So when one company acquires another company, we, we're very good on our spreadsheets to, to create these synergies from combining two entities, right? You know, cost synergies. We might be able to combine our HR function, as you mentioned. We might be able to combine a head office function, shut, mothball one industrial manufacturing plant because we've got this bigger, more efficient one. And you save money and you add to your bottom line. When you're talking about a breakup or spin-offs, the danger is you have the inverse of that, right? Yeah. You've created synergies by unifying centralized functions. And then you're going to have to, you know, from a regulatory and governance perspective, you're going to have to start to create these individual functions within these 7 businesses. And suddenly the profit that you see at a top co or a holding co level, you know, which is, you know, which is relatively, relatively strong. I mean, JD.com's profits, you know, only $3 billion a year, but it's still in a kind of aggressive growth phase of its business. Suddenly you'll see that, at least in the first few years, you'll see that drop as the business units— hopefully it will be more than made up with renewed focus and, you know, and a hunt for market share and things like that. So I'd say that, that, you know, that has got to be— it's hard to break these things apart and it's going to cost money.

Yeah, well, I guess now you mentioned that profit, because I think revenues are $150 billion, right? And they only, they only generate around $3 billion of profit. That's a wafer-thin margin, right? So when you start saying this could cost a bit to kind of, you know, one-off costs, fine, but still to kind of execute this. So yeah, there's not a lot of room there on the sort of bottom line to, to execute this without, without having a year of loss, of losses.

And it's a good opportunity to bring Amazon here, you know, maybe to bring this, this little piece to a close. So Amazon, Amazon is a brilliant case study of a kind of semi-conglomerate through verticalization. Lots of jargon in there, right? So Amazon has been the most amazing company looking at its costs. And I can just imagine Bezos back in the day going, You know, why are we paying so much for data centers? You know, why are we paying so much for cloud computing? Why don't we do it ourselves? Why are we paying so much for distribution? Why don't we do it ourselves? And actually, Amazon's margin on— profit margin on e-commerce is wafer thin. Yeah, really, really hard. You know, you know, they were loss-making for over 20 years, but it's by verticalizing, by basically owning margin throughout the supply chain. Amazon has been able to jump its profit margin. We all know that AWS, Amazon Web Services, is the key driver of growth for that company. So it's kind of— they, they own a lot of different business units, but they're all contributing to the margin and also contributing to the kind of logic of the business model. So it's just quite an interesting way, you know, you can do it well and you can certainly do it badly.

Yep, well, interesting stuff. Well, let's shift across from China, uh, let's bring it home. And well, let's bring it semi-home because I guess we're going to have one foot still a little bit over in the Far East with the fact that Vodafone and Three merging. I didn't quite realize— maybe we'll touch on this not immediately, but CK Hutchinson is a, is a Hong Kong based business. I don't know if there's any political element to all of this from the regulator's point of view, but before we kind of perhaps talk about the politics of it all, yeah, this is a really interesting one. I guess they've been trying to— there's been, there's been, I guess, ambitions of consolidation sort of right up the top of the tree of the UK's mobile network space for a long time, and it's never quite happened. And so I guess this is, this is the latest episode. So yeah, so talk me through it. Vodafone and Three merging, what's the rationale? Yeah, will it happen?

Will it happen? Yeah, well, we can definitely talk about regulation, uh, that's a big part of this story. And, you know, and we can talk about natural monopolies and oligopolies and things like that, all good stuff that we all remember studying way back in the day. Just a little bit of a highlight on the deal because it's, you know, it was probably the major deal that was announced last week. So this is a £15 billion deal to merge Vodafone UK. This is not Vodafone PLC. Vodafone PLC, you know, operates across the world and generates a lot of its revenue in the EU. Vodafone UK and 3, which is a subsidiary of Hutchison, which is the Hong Kong listed conglomerate. You know, going back to conglomerates. So this is a £15 billion deal where the equity of the 2 businesses is valued at £9 billion, and £6 billion of the enterprise value of the deal is going to be debt from the existing entities fed into this merged entity. Again, enterprise value is not just equity value, it's also the value there.

And this becomes a brand new, new entity.

It becomes a brand new entity. Um, it is going to be owned 51% by Vodafone, and there's a reason why there's 51% ownership by Vodafone, which, which, which we can talk to a little bit later with regards to regulation, and 49% from Hutchison. And the rationale, you know, we'll talk a little bit about this rationale. So Vodafone, I don't know if you followed this story, but over the last year or two there's been an activist shareholder campaign basically saying, look, Vodafone, you're, you're, you're not performing anywhere near what we expect you to be performing at. You're still investing money into loss-making businesses. You're not focusing on the real jewels in the crown of your business. Which is basically Germany, UK, Spain, etc. And A, we want to get your CEO out because we don't think he's good enough.

Right.

B, Nick Read's been responsible for a 20% decline in the share price. So means something. So, so, you know, Vodafone had to make some moves, right? And by merging with Three, what you— what they're trying to do is create an entity that's got the firepower to invest across the 5G spectrum, which is the, again, the big land grab in this industry. A bigger entity with more ability to raise capital and get, receive investment from the parent companies is going to give them a war chest to go out and compete, e.e., et cetera, in this market. They also say that the deal is going to unlock to— it's quite staggering— it's going to unlock up to £7 billion in synergies. So £7 billion in synergies, when you think about an equity value or an enterprise value of the business of £15 billion, you're basically saying that this is going to be the world's greatest value creator by just unlocking all of these amazing synergies from things like, you know, marketing, unification, enhanced mass sharing capabilities, which is something that the industry does quite a lot of. So, you know, again, who knows where that number came from. And often these numbers are whatever they need to be in order to work from a deal rationale perspective. But I think that that is going to be, you know, I can't see $7 billion coming out of, you know, coming out too quickly.

That's ambitious. Sounds like a lot of job losses.

There is going to be some job losses.

Yeah, I think the regulators might feed into the kind of regulators' list of things to be concerned about here.

Yeah, this is really interesting. We can move on to— we can move on to regulation. And as you said, there have been 4 big players in the in the market, in the mobile phone operator market: EE, O2, Three, and Vodafone. Already that's quite a concentrated market when it comes to choice, consumer choice. And back in 2016, the EU regulators blocked Justine's first attempt to link Three with O2. They said, yeah, Four is okay, Three is too small a market to give consumers the choice that they need. But there are certain markets, there are certain markets that are naturally oligopolistic.

Or actually, that's a great word, by the way.

Can you say that? I try and say it about 10 times a day. Um, so an oligopoly is a market with 3 or 4 major players, and sometimes that is a bad thing because it restricts competition, you know, and prices are driven up and consumers don't get choice. But often these markets, as goes the argument from Vodafone and Hutchison, these markets could only support 3 or 4 big players because in order to be a big player in this market, you need scale. Yeah, you need to be a national operator with the infrastructure capabilities to run this network. You need to have access to significant capital be able to improve your network through time. There are not that many companies— subscale companies will not survive in this industry. What Hutchison's saying is, since 2019 we've been operating, our profits have been below what was the capital— so cost of capital, how much it costs to raise new money. Our profits are not basically covering that. Yeah, that is a clear example of a subscale business. And what they're basically saying is, you know, if you don't let us do this, then it will be 3 anyway, because we'll just— we won't be able to survive.

Yeah.

So, you know, regulators, take a little look at this. And by the way, we are committed to investing £11 billion in the 5G network, which you're already lagging the US and other countries in. So come on, please come back to the table, talk to us, take another look at this. Don't just say you're going to block it because we think this is probably good for everyone.

So what's your, what's your sense if you had to put a bet on it today? What's— would you bet that this is gonna pass and they will merge and it will go ahead, or do you think it'll get kiboshed like it did a few years back?

So if you'd asked me that yesterday, uh, when I was doing the research, I would have said it probably I would put it more likely that it would pass. I think they've got a relatively strong argument. And, you know, the murmurings are that the CMA may look slightly more favorably on this deal than they have on certain deals in the past. But then I started looking into, I started looking into this market. And so a lot of the argument for this combination is, look, two subscale businesses, we can't operate independently, we need to team up together, in order to share resources, right? But actually, in this industry, resource sharing already happens. Right. So, so colocation is a big thing in this industry, basically sharing infrastructure. So mobile phone operators will team up together to share their masts and their cell sites. So they're already doing these deals to kind of benefit from shared capacity which slightly, not completely, but slightly undermines the argument that they need to merge together in order to do this kind of stuff, you know, in order to realize these economies of scale, in order to realize these synergies. So whether the CMA lands on the side of, you know, actually better 3 big beasts than, you know, 3 big beasts and a subscale beast. Yeah. Yeah. I'm, you know, I'm on the fence, 50/50, you know, come back to me in a year's time. Because it will take a year plus probably to go through.

Right, yeah, I was going to ask on timescale. So yeah, maybe a year, 18 months. So maybe finally then, 51% Vodafone, 49% Hutchinson. So why the— why those numbers? Should we be reading anything into that?

Yeah, so there's a couple of reasons for this. So the first is— so the first is the Vodafone also they, they slightly want to be the senior partner because, well, they have an option that if the business, the combined business, reaches a certain enterprise value, they have the option to buy the whole thing. Okay, so if the business exceeds an enterprise value of $16.5 billion, which is not kind of inconceivable, they get the right to buy the whole business after 3 years. So they already kind of want to be the senior party in this. They're a slightly bigger network in the UK. They're actually putting in a little bit more equity as well. So there's that argument that they should be the senior party. But also from a national security perspective, it is seen as quite important that a critical piece of British infrastructure is owned, you know, from a percentage ownership and a control perspective, by a UK PLC. So we're still in this Huawei national security, let's try and make it as easy as possible to get this deal through, hence we'll make Vodafone the senior party. And I think it makes sense for a number of other reasons as well.

Okay, interesting stuff. Uh, we shall track that story. As you said, it could be rolling for many, many months a year plus. So we'll keep track of this as things play out. Let's move on to our final topic. And well, let's talk Subway. Did you know, fun fact, there are 37,000 Subway branches globally? That's a lot of one foot sandwiches that are getting sold there. Um, so talk, talk us— talk to us, what's going on? There's, there's a buyout in the offing.

Yeah, so Subway's up for sale. Um, Subway is up for sale. Uh, JP Morgan is leading the sell-side process to sell Subway. They initially wanted $10 billion for the organization, but they're now aiming to reach about $9 billion. Um, there are a lot of private equity firms sniffing around. The first round saw 20 PE firms interested. The way that a process like this will work is that you winnow it down, 20 down to 5, to a preferred, and then exclusive, and then you, and then you did the transaction. So from 20, we now have 4 or 5 private equity firms that are interested in buying this company. This company is a really interesting one. Obviously, we all know it from, you know, from virtually every high street, but it is franchise. It's a franchisor, so it doesn't run the company, it doesn't run the stores. It is a franchisor that provides material expertise, brand marketing, to individuals that want to set up, and the franchisee pays a franchise fee, uh, to set up, $10,000 to $15,000. It's actually really quite low compared to McDonald's or something like that, you know, hundreds of thousands of dollars. And then they pay 12.5% of gross sales minus tax every week back up to Subway, right? So Subway, the business model, you know, a franchise business model it's quite a nice one if it works. You're up there, you're doing the marketing, you're giving the importance, you're helping stores upgrade, you're making sure that quality standards are uniform, but you're not actually taking on the risk of an individual store. That's the franchisee. And you get these nice royalty payments, franchise payments, every single week filtering up for someone. So it's an interesting business model, and it's important, this business model, because it goes into how this thing is going to be financed. So, so when private equity firms, or, you know, any acquirers, are looking at buying an asset, buying a business, they have a range of options available to them in terms of how to finance this. And we've spoken previously on the pod about the blend of debt and equity and You want, you know, you possibly want as much debt as possible so that your equity could be multiplied upon exit. But actually the reality of a capital structure is much more complicated. So the way it works is it's all about risk and return. So at the very, very top of a capital structure, when I say capital structure, basically the 100% of financing that goes into a business, at the very, very top, the most risky form of capital that you can put into a business is ordinary equity. The reason why that's most risky is because if the company goes bust, they are the last people to get the dregs of the business, right? They are paid out the last. So that is proper risk capital. Right down at the bottom of the spectrum, the most secured The most safe asset capital is what we would call senior secured lending. This is where a bank or an institution lends to a company but is secured on the assets that that company has. A bit like taking out a mortgage, you know, the bank lends me money, but they are secured against the value of my property. So I'm pretty safe, you know, I don't get a great deal of upside, the equity owners get the big upside if this thing goes, um, goes into space, go, you know, grows very quickly, but I'm pretty safe. And then all the way in between you have these different levels of risk and return, you know, from senior secured all the way to like common, common stock, ordinary equity. And why this is important for the Subway story is because they have got a really interesting source of revenues that can be what we call securitized. So the article that came out in Bloomberg a couple of days ago was about this thing called whole business securitization. And the fact that, uh, potential buyers of Subway can get access to up to $3 billion out of the $9 billion purchase price in whole business securitization. What this means is that banks will lend to these private equity firms, these private equity buyers. Banks will lend at— based on the royalty payments or the franchise payments that are filtering up to the business. So every week there is some certainty that these 37,000 stores are going to pay 12.5%. That's a thing that can be securitized. I, you know, I've got access to that security. I'm pretty confident that that thing is going to get given. And if it's— and if Subway goes bust, I still get those fees coming to me as a business.

Yeah.

So I can lend you a lot more than you would otherwise be lent because I've got security through those royalty streams. Whole business securitization doesn't exist outside of a kind of royalty fee model. You can have secured businesses, but this notion of whole business securitization is quite unique, um, and this is why it's quite an interesting story when we're trying to learn a little bit more about capital structure.

So can I ask then, so that sounds like— so let's just take that franchisee who's operating their business, you know, they're at the coalface, you know, customer-facing, coming in trying to sell sandwiches, whatever, right? But they— so they're a business, like a normal business. They're generating sales and revenue, and a portion of that's getting sent up to find the, the subway business. What's— but I don't understand, like, from a bank who's lending, why would they see that royalty fee— why is that less risky than a normal company's revenue and therefore profits? Well, is it just because there's a— you've got 37,000 of them, so perhaps the risk is therefore diluted? Is that how it works?

Yes, it's a really good question. It's quite a tough one to unpack. So if I was a bank and I was looking at these royalty payments I would see the agreement between the franchisee, the individual store, and the franchisor as an asset. That long-term agreement, 5 to 10 years, 12.5%, you know, relatively stable income streams across a 37,000 portfolio. As I could see that as an asset, I would be willing to lend against.

Yeah.

So that if the top co went bust, I still can get that revenue stream because those companies are still existing underneath. Right. So the kind of the risk is certainly spread and the contract length is quite visible. So there's visibility of income. And what you're essentially doing is you are packaging millions of Subway customers into 37,000 consistent revenue streams. As a bank, I would feel so much more confident lending against than lending against the 2.5 million, you know, buyers of a Subway sandwich every lunch. So it's just a different risk profile, uh, and it has— it mirrors a little bit of the mortgage-backed securities, right, kind of combinations that we saw, uh, back in the dark days pre-2008.

So I guess then, thinking back to your capital structure, then this this comes— it's more down towards the sort of senior secured debt end of the spectrum. And therefore I would assume then that the interest rate on that loan is lower.

Absolutely. Absolutely. And you will be able to potentially borrow more.

Right.

So the article goes, there's potentially up to $3 billion available in whole business securitization and an additional $2 billion available in traditional bonds and loans. So you're getting 5/9 of your capital structure potentially in debt. Yeah, but actually, weirdly enough, just to kind of move this on to the second interesting part of the story, that $5 billion number is the amount of money that JP Morgan— remember, JP Morgan is advising Subway, not advising the buyers— is the amount of money that JP Morgan is offering as what's called staple or bridge financing. So this is a really common thing in private equity or in deal making in general. If I'm a bank with a big balance sheet acting on behalf of Subway and we want to get this sale done by July, I can sweeten it by saying you're buying Subway, but you're also buying this $5 billion financing package that we as JPMorgan have bespoke put together for you for this acquisition. So the buyers don't need to scramble around, certainly for the first year, thinking about that $5 billion. They just buy Subway and have the debt that's already arranged, and then JP Morgan can work with the eventual buyer to see how to, you know, maybe turn that into a longer-term debt instrument or whatever it might be. It's really, really smart.

It's— so there's no, like, half of me wants to say, well, hang on, isn't there a bit of a conflict of interest there where JP Morgan want to get this deal done ASAP, really, because of the fees they'll generate from the financing product which the buyers are going to be paying for. And therefore, a bit of a conflict maybe in terms of representing Subway, the seller.

Yeah, it's a really good point, and you'll find this all the way through corporate finance. And you may not call it an explicit conflict of interest. But the best representation of this kind of packaged offering is if you work for a big lender that isn't an amazing M&A advisor, you might well get a little ticket on the M&A deal, you know, not right at the top as the lead arranger, but maybe, you know, somewhere, you know, a little, a little tombstone for your work, even if your M&A team didn't do a great deal. It's because you're the biggest lender in the syndicate. So, you know, there is a little— well, there's definitely overlap. If I provide you the financing, I want to get a bit of advisory fee. If I'm going to be the lead advisor, well, why don't I help lead the, you know, the financing as well? So it's not necessarily a conflict of interest, but there's certainly— JP Morgan is going to benefit both from the advisory, the arrangement of the debt, and then working with the buyer to sell down the debt and restructure it afterwards. So they've got a nice ticket here.

They do. And I guess, yeah, I mean, thinking back to like competition, uh, commissions and stuff, it's almost like JP Morgan— I mean, we're going veering off into a different conversation here, so we won't go down this path— but JP Morgan, they're such a beast that, you know, they do have maybe that power to kind of demand whatever fees they want, right? Because there's just no one else as big as them that can kind of pull off these deals. And I guess for Subway, thinking about the competition, sorry, that point about them, the conflict of interest point, maybe I guess for Subway, the attraction is we want to just get this deal done. We want to get it done now. We've decided to sell, let's sell. And right, if JP Morgan can provide that financing bridge, it just speeds up the deal, I guess.

So that's the appeal. Yeah, I'd be more likely to get, if I wanted a relatively quick, efficient process, why not go with JP Morgan if they're going to provide the stable financing? Obviously, JP is not the only organization that does this, but they're certainly, certainly too big to fail, as, as we've discussed before.

Who owns Subway now? Is it, uh, yeah, who's the current owner?

Is it publicly listed, or is it not publicly listed? Private equity-backed.

Okay, so it is private equity-backed, just wanting to cash in on, uh, what— it's time to exit and return funds, I guess. So they're just kind of rolling it over to a new set of private equity firms. I see.

Um, it's actually owned by the De Luca family, so it's kind of privately owned.

Oh, okay, fine.

Okay, not private equity, but privately owned. So they obviously want to cash out.

Yeah, it's just time. Yeah, cool. Well, very interesting. So next time I step into a Subway, which I confess I don't do on a regular basis, but I'll ask the franchise owner— not that I'm sure they won't be behind the counter, but maybe they will— I'll ask them, I wonder what the franchise owner thinks about all of this. I guess for them it doesn't really matter, right? Who the big boss is upstairs. You just gotta send the money.

Yeah, could not care less. Yeah, cool.

Very interesting stuff. Well, thanks very much for your, for your insights, and we'll leave it there for this week's Deal Room episode, and we'll be back next week for more interesting insights. Thanks very much, Stephen. Take care.

Thank you, Piers.