Capital Growth Options

Over the past decade, the U.S. fitness facility industry grew from $8 billion in revenue to more than $16 billion by 2005. This phenomenal growth has been fueled by a steady influx of growth capital, both from traditional and non-traditional sources. In just the past few years, the fitness industry has seen regional players such as Equinox, Lifestyle Family Fitness and X-Sport Fitness experience rapid growth as a result of dynamic business plans and large infusions of capital. Concurrently, large-scale players such as 24 Hour Fitness and Fitness First have leveraged traditional and non-traditional sources of capital to expand their empires. Finally, new players such as Exhale, a mind/body spa, have been able to establish successful business models by their ability to raise capital and put it to work for the benefit of their shareholders. The fitness industry is well-positioned to experience greater growth than it has over the past 10 years. Socio-demographic factors such as an aging population (baby boomers) with higher discretionary income, the emerging echo boomers, the growing pandemic of obesity and a large untapped market of prospects (only 15 percent of the domestic market belongs to a health/fitness facility), all comprise a platform for unprecedented growth in the health/fitness facility industry. To ensure you are putting your club in a position to benefit from these factors, let us take a look at the three most common strategies for raising the necessary capital for fueling growth: bank financing, private equity/venture capital infusion and sale leasebacks.

Bank financing

Historically, bank financing has been the primary strategy employed by both small health club businesses and large fitness companies to raise capital for growing their business. A fitness facility operator who is interested in obtaining bank financing should keep the following in mind: Equity requirements. Banks usually require that the borrower have equity equal to at least 30 percent of the amount of debt being requested. In the case of a new business seeking debt financing from a bank, the amount of equity needed to obtain the loan might be as high as 50 percent. For large investment groups seeking to highly leverage themselves, the amount of equity might be as little as 15 to 20 percent of the debt. Guarantee requirements. For most small businesses, the owner is required to sign a personal guarantee on the loan. If the small business is a partnership or corporation, the bank may require all owners with a 20-percent stake or greater in the business to sign a personal guarantee. For larger corporations with a proven record of profitability, banks will likely require a corporate guarantee in the place of personal guarantees. Limitations. Unless your facility has physical assets, the amount of debt a bank will extend is based on the cash flow performance of your business. In most cases, banks will limit the debt to no more than 50 percent of the cash flow value of the business, which is based on a market multiple ranging from five to seven times the existing earnings before interest, taxes, depreciation and amortization (EBITDA). For example, a club with an EBITDA of $1 million might have a cash flow value of $6 million (e.g., $1 million times six), meaning the bank would extend total debt to $3 million. Bank covenants. Banks will place covenants on the loan. Covenants are specific structured terms that a bank uses to secure or protect its loan. These covenants may include the following:

• Debt coverage ratio or interest coverage ratio (e.g., the amount of cash flow available to cover interest payments). In most cases, this ratio will range from 1.1 to 1.5.
• Timeliness of debt payment.
• Assets used as collateral retaining a certain value.

Like all financing options, bank financing has benefits and risks. If the ultimate goal is to retain personal ownership, this is an option that should be considered. With bank financing, you own your business and its assets, so long as you do not break the covenants. Furthermore, you have the ability to pay down your debt early, allowing you to own your business and its assets, unencumbered. The downside is that you are using your business, and often your personal assets, as collateral, which means you may be putting your business and personal finances at risk.

Private equity/venture capital infusion

In the last five to 10 years, private equity and/or venture capital has become a significant resource for fitness industry growth, particularly for medium and large operators. These operators often want a significant infusion of capital, where control over operations is not essential. Large club operators, such as 24 Hour Fitness, Equinox, LA Fitness and Gold's Gym, as well as smaller operators such as Exhale, Lifestyle Family Fitness, Spectrum Clubs and Sport & Health, have all relied on either private equity or venture capital to help fuel their growth. Private equity represents funds provided by individual investors, more commonly referred to as Angel Investors. In most instances, Angel Investors place no more than a few million dollars into one business. Investment banking groups have the ability to package multiple Angel Investors, allowing a fitness operator to raise a much larger amount of equity. These private investors usually look to gain an internal rate of return (IRR) of at least 20 percent, and as high as 30 percent, over a period of five to seven years. This yield is achieved by a lower annual return with a significant return at the end of the five- to seven-year investment term. Often, the private investors in a business are given stock and voting positions on the board. In essence, private equity investors become owners of the business, which may reduce the amount of control the operator once had. If an operator of four fitness centers wanted to expand his or her business into a regional chain with 20 or more locations, the operator might seek equity from a venture capital group. Venture capital groups manage funds that contain monies from several private investors. These groups seek to generate very high levels of returns (30 to 40 percent IRRs) to offset the inherent risks present in their investments. In most instances, the funds have a short-term life span of five to seven years. Managers of these funds are primarily interested in achieving their yield requirements, and will do whatever is necessary to ensure that the return targets are being met. Control over the management of the business is a likely mechanism the fund will incorporate to keep a pulse on profitability. These groups will often keep the existing management team in place; however, they will not hesitate to bring in a third party management team if they feel their investment is failing to achieve the expected returns. This option allows owners to gain significant capital to spur growth, but they may relinquish control and a large part of their business to the investors.

The sale leaseback

A third approach, available only to those who own the property on which their facility is located, is called a sale leaseback. The owner of a property sells that property to a real estate investment trust (REIT) - a corporation that combines the capital of many investors to acquire or provide financing for real estate - and then simultaneously leases it back from the investor. Large, real-estate-heavy operating companies have used sale leasebacks to raise growth capital, such as Lifetime Fitness, 24 Hour Fitness and Wellbridge. The lease agreement resulting from a sale leaseback is referred to as a triple net lease, also known as Net-Net-Net or NNN. In this long-term lease arrangement, typically 15 to 20 years, the tenant or lessee agrees to pay all real estate taxes, building insurance and structural maintenance on the property, in addition to rent. In most cases, REITs will look to incorporate rent escalators during the life of the lease based on annual changes in the Consumer Price Index. An REIT, like a bank, does not get involved in the operations of the business. REITs will have little to no authority over the facility's management team or operational approaches, but it will be involved in capital spending into the asset. However, you are required to maintain the property up to standards set by the REIT - it will want to be satisfied that, if you cannot meet rent obligations, the space could be released to another operator at a rate equal to or greater than the negotiated lease rate you're paying. The REIT may also want assurances that the property can be converted for another use in the event you decide to cease operations. Why sell your real estate when it is an asset to your business? The answer usually involves fast cash. If you enter into a sale leaseback, your business gets a quick influx of capital. An REIT will often provide 100 percent of the property's value, though the resulting rent will generally be higher than typical debt service. Important questions to ask when researching a potential sale leaseback arrangement include whether or not it will include the option to buy back the property at a future date.

Weigh all of the factors

In light of the demographic support for the next decade of growth in the fitness industry, now is a great time to start positioning your business to benefit from these market factors. While traditional debt, private equity and REITs can all be great sources of growth capital, it is important to evaluate your business and its goals when determining which source best fits your interests.