Does Private Equity Create or Destroy Value?

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Private Equity Firms and Restaurants: Motivations, Track Record

Recently, the press has been full of reports of private equity (PE) firms receiving outsized returns on prior restaurant investments. Examples include the reported Sun Capital 13 times return on its 2003 Bruegger's investment, Olympus' Partners reported 8 times return on its K-Mac predominantly Taco Bell franchisee group, Falfurrias selling Bojangles (unit counts up 30% since 2007). CKE Restaurant's is now working a dividend via new debt for its owners, as did Dunkin Brands in late 2010.

We are maintaining a log and count so far 62 separate and distinct chain restaurant brands owned by PE firms, from large to small. That count will soon equal the number of publicly traded restaurants. And three big chains, Arby's, Long John Silver's and A&W were put out for sale in January 2011, and could join the PE ranks.

PE Economic Motives: The age-old laws of economics and investing hold here: buy low, sell high. Take money out of the business when you can. Lever up, pay debt down, then lever up again. Try to make improvements in the business. Hold for a 4-7 year timeframe. Think exit strategy from the beginning. Use OPM (other people's money) if at all possible, hold your cash equity infusion as low as possible so long as the debt isn't too high.

PE firms hope to deliver a 25 % plus annual compounded return on capital invested.

The spate of 2010 and 2011 restaurant activity has to do with (1) a general reopening of lending after the 2008-2009 recession, (2) lower corporate debt rates, and (3) PE firms with funds that must be put to use. Larger cash on cash percentage returns seem possible for "older" deals, when the required equity infusion was lower, at 20-30%, versus now. But the returns depend and will change over time.

The private equity firm promotes operational improvement, and synergiesvia a "buy to sell" mentality to get their investment back and realize a trading profit. With a 4 to 7 year term focus, they utilize both operational value creation and leverage and financial engineering. The balance depends on the PE firm's own expertise and focus. PE firm ownership doesn't guarantee success, however.

Highly franchised businesses, especially national brands, command a valuation premium since the earnings is thought to be more predictable and there is less (but not no) capital expenditures associated with a franchised system. Multi-unit franchisees are valued a bit less as they have a smaller development universe typically.

Is this bad or good for the brands? We don't know yet. Not much data is available.

In 2010, we looked at 2003-2007 era private equity deals that failed. Since data for privately held restaurants aren't much accessible, we defined failure to be either Chapter 11 or 7 filing or where unit counts declined. About 30% seemed successful, 40% in some mid-state or not determinable yet and about 30% had failed.

Interestingly, the success factor seemed to vary based on the brand strength, and position in the marketplace. The purchase price multiple, a proxy for debt, didn't seem to be greatly associated with the success or failure.

What about the franchisees?

In all of these chains, franchisees do all the customer execution work; bear the expense of the initial investment, ongoing capital expenditures and new unit expansion. They pay the royalties, and borrow the bulk of the funds needed for expansion. They are highly affected by credit market conditions.

Franchisees want buy in, dedication, and culture, since they have bought in, often for life. PE firms might be smart to leave competent management in place that can further build the culture and promote franchisor- franchisee coordination and unified accountability.

In relating to the PE firms, franchisees must realize that the PE firm is using both "trader skills" via a so called "buy to sell" mentality as well as business management skills to get a good return. They certainly want to make the business better. But each PE firm is different and has different motives and capabilities.

Franchisees should figure that businesses would be held for some time to recover investments but trader, market conditions would rule the timing. The exit plan might not be re-entry to the public markets, but might be sale to another PE firm. As other PE firms raise money, they need to put the funds to work, too.

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This article is timely.

Within the last few weeks, MidOcean Partners owned Sbarro's went bankrupt, and Castle Harlan owned Perkins & Marie Callender's defaulted on its debt.

Also, PE firms this summer are bringing Dunkin' Brands public.

This subject merits more examination.

This is an interesting write-up and I appreciate someone is out there keeping a tab on PE's interest in the world of franchising. I believe a franchise system is a unique asset with many unknown moving variables at play.

As a Dunkin' Donuts franchisee, I'm glad to see the acronym OPM defined - Other People's Money. Mr. Kosman brings up a great example with MidOcean Partners because they purchased Sbarro with only 40-45% leverage. However, after taking ownership of Sbarro they took out more debt to pay shareholder dividends by fully leveraging the acquisition price - $450M. After loading Sbarro up with debt, MidOcean Partners recently took Sbarro into Chap 11 Bankruptcy. The creditors are now taking equity stakes in lieu of their principle repayment. Sbarro's will most likely go public within 5 years after emerging from this Chap 11 bankruptcy to cash out the one time creditors.

As PE benefits, I find it hard to believe that the franchisees can get the full support of their franchisors. Seems to me, the franchisor is now focused on squeezing the cash out of the business versus reinvesting into growth and product development.

Anyone have any thoughts on the following questions:
1) Why is it that a franchisor is more valuable to a PE shop when their system is mostly franchised?
2) Is there a relationship between high OPM leverage and the amount PE can earn?
3) When a system has high OPM are the franchisees viewed as Variable Interest Entities (VIEs) by the franchisors?
4) Does the model require a bunch of independent contractors to get flushed out of their equity in order for a handful of suited PE folks to walk away with the loot?

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