Part 2- Private Equity in Franchising: The Upside and the Downside

by Ed Teixeira

In part two of my article on the role of private equity in the franchise industry, we look at which kind of franchisors are attractive to PE firms, the evaluation process, along with the impact on the franchisees of acquired companies and what’s in the future.

The Franchise Targets

Although restaurant franchises receive the bulk of attention from PE firms, other franchise segments including home care, children’s services and other concepts that appeal to a broad consumer’s base are of interest.

John A. Gordon of Pacific Management Consulting Group  provides some interesting data regarding the role of private equity firms in the franchised restaurant business.

Gordon stated: “We are maintaining a log and so far count  62 separate and distinct chain restaurant brands owned by PE firms, from large too small. That count will soon equal the number of publicly traded restaurants. And three big chains, Arby’s (WEN), Long John Silver’s (YUM) and A&W (YUM) were put out for sale in January 2011, and could join the PE ranks.”  Note: In June of this year all three were acquired. According to Gordon:

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

“Private Equity Fund interest awakens when the franchisor hits the level of $5 million to $10 million of earnings before interest, taxes, depreciation and amortization (EBITDA), a surrogate for operating cash flow” From the IFA 2011 Legal Symposium, Private Equity Program

Although the majority of deals involve larger franchise systems, some PE funds have an interest in multi-unit franchisees. For example, a recent acquisition involved The Blackstone Group acquiring a New Zealand Burger King franchisee that has the exclusive franchise development rights for the Burger King brand in New Zealand and the region. They operate 75 Burger King restaurants throughout the country.

The Franchise Evaluation and Due Diligence Process

A private equity investment should be viewed as validation of the franchisor's business model and future prospects for growth and system success.  The PE Fund employs rigorous investment criteria and careful diligence efforts, usually taking into account the interests, mood and attitude of the franchisees toward the franchisor.
Source: IFA 2011 Legal Symposium

For franchisors that are contacted directly by a PE group or desire to seek out specific PE investors there are specific questions that a PE group will consider:

• Does the franchisor generate a sustained and positive cash flow?
• Do the majority of franchisees have positive cash flows and strong earnings?
• What is the potential for increased new franchise sales, to grow the network?
• What is the state of franchisor-franchisee relations and franchise litigation?
• Is there a component of successful corporate locations?
• Is there a strong franchisor operations and sales structure?
• What is the level of management competency and leadership?
• What is the situation regarding current franchise agreements to include expiration dates and renewal options?
• Are there opportunities to acquire existing franchise rights?

Private equity groups will consider a large number of investment opportunities before settling on specific companies. A partner or analyst will zero in on specific areas and in particular, a company’s financial performance and trends. There is an added layer to a franchise company, namely, the franchisees financial performance

A franchisor that has an interest in selling a majority or total ownership of their company should prepare for a very detailed due diligence process.

Impact on the Franchisees

Franchisees that are a part of a company that has been acquired by a PE group can expect a number of changes. Some may be positive while others could have a negative impact on the franchisees. Since private equity firms have an obligation to investors in their PE fund they seek an exit strategy with high returns through capital appreciation.  Strategies can include an Initial Public Offering, a management buyout or a secondary buyout, which consists of another PE group making the acquisition.

When a private equity investment is made in a franchise company there is the potential for change:

Positive impact for franchisees:

• Adding new franchisees could enhance the value of the brand and increase the value of an existing franchise.
• The PE group may bring specific capital to acquire existing franchisees in strategic locations.
• To satisfy their need for growth and sales the new ownership may provide qualified franchisees the opportunity to acquire added locations.
• Certain franchisees may become part of a management buyout group.
• Franchisees could receive a financial benefit from an IPO

Negative impact for franchisees:

• If the PE group is inexperienced in franchising there could be conflicts with those franchisees that have more experience and knowledge in operating the business.
• The PE group may desire to implement new products or marketing strategies that may be resisted by franchisees.
• There could be issues regarding the administration and control of an advertising fund.
• Cost cutting by the new majority owners could lead to a reduction of services and support to franchisees.
• There could be financial issues that may reduce the value of individual franchises.

There have been some negative outcomes from particular PE transactions.

Josh Kosman, the author of “The Buyout of America” recently commented on the bankruptcy filing by Friendly’s Ice Cream.

Always remember; the objective of the PE group is to obtain the highest return for its investors. This objective can be realized in a way that investors and franchisees benefit or where the franchise and its franchisees lose.

Private equity groups will continue to seek investment opportunities in franchise companies. As the growth of PE funds continue to increase and fund management becomes more experienced in operating franchise companies there will be more investments. Look for more creative ways for PE groups to target and invest in franchise companies. This will lead to more opportunities for franchisors and multi unit franchisees. This objective can be realized whereby investors and franchisees benefit or where the franchise and its franchisees lose.

© 2011 FranchiseKnowHow, LLC

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