The Role of Private Equity in Franchising: The Upside and the Downside

By Ed Teixeira

This is the first of a two part series on the role of private equity funds in the franchise industry. We’ll examine a number of issues; including, why there has been a dramatic increase in PE investments in franchise concepts, the benefits for franchisors, the impact on the franchisees of acquired companies and what’s in the future.

A Bit of History

When working as an executive for several publically traded franchise companies during the 1980’s, I would occasionally participate in meetings with investment bankers and private equity groups. On a number of occasions we were told that corporate owned locations were preferred over franchise locations. In some cases, the strategy of acquiring franchisee locations for the purpose of converting to corporate operations was discussed as a way to make the investment or acquisition more attractive. When it came to investing in a franchise company there appeared to be ambivalence.

The Preference of Corporate over Franchise Locations Included:

1. Corporate locations were easier to control compared to franchisees
2. Sales revenues and earnings were not shared with franchisees
3. New business strategies and marketing programs could be implemented much more quickly
4. A poor performing corporate employee could be simply discharged compared to terminating a franchisee, which could be a lengthy process and lead to litigation
5. The exit strategy for the investor or acquirer would be easier to execute especially in the case of a future IPO.

How the Times Have Changed

In the recent past private equity firms have taken a more aggressive interest in franchise businesses. This has led to investments in franchisors both large and small. Reasons for this interest include; the growth in franchising, diversity of franchise brands, increase in available private equity investment capital and the favorable returns from private equity funds.

For example; the Private Equity Growth Capital Council reported that private equity firms invested more than $148 billion in 1,243 U.S. based companies in 2010. Private Equity Council President Douglas Lowenstein stated that: “Investors are drawn to private equity because the returns delivered by private equity funds far outstrip those from many other investment opportunities, including the public equity markets. Between 1980 and 2005, the “top quarter” private equity firms, on average, produced annualized net returns for pension funds and other limited partners of 39 percent. During the same period, the Standard & Poor’s 500 index posted returns of 12.3 percent” stated Lowenstein.

The Capital Roundtable states in a PE Franchise conference brochure: “There has also been substantial activity with PE firms buying large franchisees with 25 to 50 Burger King, Taco Bell, or other QSR units -- companies that typically have good cash flow, and an average of 10 to 15 million EBITDA selling between 4.5x and 5.5x.”

Examples of PE Activity in the Franchise Industry:

• Roark Capital has 19 franchise brands in its portfolio that represents almost 8,000 locations generating more than $4.5 billion in system sales. Their portfolio includes well known brands as Auntie Anne’s, Cinnabon, Arby’s and Carvels. A recent investment was made in Il Fornaio Italian Restaurants and Bakeries, a small franchisor with 22 locations.
• Bain Capital ranked the seventh largest private equity firm by Preqin is an investment firms that manages approximately $66 billion in assets. Bain has invested in Dunkin Brands, Gymboree and Dominos Pizza Japan.
• Sun Capital Partners includes in its portfolios, franchisors Boston Market, Captain D's Seafood Kitchen, Fazoli's Restaurants and Friendly Ice Cream. Note: Friendly recently filed Chapter 11.
• Boston based Gemini Investors helped take Buffalo Wild Wings public and has made an investment in the Jan-Pro a commercial cleaning franchisor.

The level of interest in franchising as a successful business model and the increased investment activity by private equity groups has changed dramatically. A major factor has been the growth of private equity funds and the emergence of franchising as a viable and scalable business model.

Factors That Make Franchising Attractive to PE Firms:

1. Individual owner operators will protect their business and develop their market.
2. New franchise business concepts such as home care, children’s education and recreational services and health and fitness concepts have broad consumer appeal.
3. An on-going royalty stream that can service financing obligations
4. Since capital expenditures for upgrading and equipping locations are franchisee obligations these expenditures or CAPEX are lower compared to corporate owned networks
5. The multiples for franchised restaurant companies are higher than for non-franchise companies.
6. The number of multiple franchisee operations in well known brands.

There is little doubt that private equity firms have a significant interest in making investments in franchisors and to a lesser degree franchisee multi-operated franchises. In the next article we’ll look into where the PE franchise trend is headed, what can go wrong, what makes a franchisor attractive and other commentary.

© 2011 FranchiseKnowHow, LLC

Ed Teixeira is the President of FranchiseKnowHow, LLC. He can be reached at franchiseknowhow@gmail.com