Private Equity Climbs on Board

Big money, in the form of private equity, is finding a home in franchising, and bringing big promise to area developers and multi-unit operators-and to franchisors and franchise executives as well.

For franchisees, it means a chance to build out an area more rapidly, or to expand geographically. For franchisors, especially new or smaller ones, it offers a way to grow their brand faster than through just bank loans and new franchise sales. And for franchise executives seeking bigger challenges (or salaries), it means expanded job opportunities as demand for their skills increases.

"My impression is that there is serious money from funds or institutions that is available to significant transactions on the franchising side," says Don Zale, who at 72, is Palm Beach Tan's first franchisee. Zale, who entered franchising almost 20 years ago, was CEO of his family's retail jewelry business, Zale Corp., when it was acquired in 1986. Today, following a successful run as a multi-unit Blockbuster developer in the greater Washington, D.C. area, Zale hopes to repeat that success with Palm Beach Tan.

Zale also presides over NewCourse Capital, a private investment firm he established after selling Zales. Recently, he has received inquiries from investors looking to participate in franchise and other investment opportunities. "I'm talking about anywhere from $15 million to $50 million investments. Those are some pretty significant numbers," he says.

Why now? "I think it's probably because there have been some very successful area developers who have gone in, whether it's been for KFC, Pizza Hut, or whoever, and have put together groups of upwards of 100, even some cases 150 to 200 restaurants," he says. "Those people are very sophisticated businessmen who have created very sizable organizations that are profitable and well-run-and in a lot of cases, run better than the franchisor."

Lois Marshall, president of franchise executive recruitment firm the Marshall Group, has been kept busy lately by investment firms seeking to hire top-level managers with franchise and operational expertise to complement the financial and business expertise the equity firms provide.

Marshall, who has been observing the franchise industry for nearly 35 years, says some of the largest, most prestigious private equity firms are taking a new look at franchising-and not as short-term investments to strip and flip, but as investments to build over five to seven years. After that, the brand could be sold, retained as an annuity-type investment, taken public, or be subject to some other liquidity event.

Large private equity firms have been investing in franchises for some time, as minority or majority investors, and through outright purchase. Examples include Meineke (2004), Liberty Fitness (2003), and Burger King (2002). And Roark Capital Group owns six brands since it began buying franchises in 2001 (see below). Two recent developments:

In late September, Castle Harlan Partners IV, a $1.2 billion investment fund, completed the acquisition of The Restaurant Company's 483 Perkins Restaurant & Bakery units (152 company-owned and 331 franchised) for about $245 million. Revenue was approximately $348 million in the past year.

And in late October, at least two different consortia of some of the world's biggest private equity firms had made competing bids for Dunkin' Brands, owner of the Dunkin' Donuts, Baskin-Robbins, and Togo's brands. Estimates of the expected sale price hovered around $2.5 billion for the company, which reported $4.8 billion in global revenue last year.

Okay, big money loves big franchising. What's different today is that in addition to a spike in the interest large funds are taking on the franchisor side, smaller private equity firms are looking to invest on the franchisee side.

The result of all this new interest-and the accompanying influx of cash into franchising-"will change the face of franchising like never before," says Marshall, who has been tapped by to find franchise executives to manage and operate the brands acquired by these large funds.

Why now?
So why have franchises and multi-unit operators become hot properties for private equity firms?

Hans Sohlen has been involved in franchising from a financial vantage point for the past 20 years, raising capital and putting together deals for both franchisors and franchisees. He sees similar changes to those described by Zale and Marshall.

At the macro level, he says, franchising has matured. One result is a much larger asset base than in the past. This presents a larger target to investors, as well as a chance to spread the risk and increase profitability by improving efficiencies.

With more assets deployed, he says, it's easier for savvy investors to leverage a brand by selling or improving the management of the brand's real estate and overall business. "There's just more money in the field because you have so many more locations out there. And you have so many more larger, consolidated opportunities, more multi-unit opportunities," he says.

Also, he says, the role distribution plays in the U.S. economy has risen dramatically in the past 25 years as the nation continues its shift from manufacturing to retail. As the importance of franchising as a "delivery system" to the retail customer has grown, so has investors' interest in franchising.

"There is money to be made here. And as soon as you start to smell that, you start to get a little bit more infiltration of the Wall Street side," says Sohlen. "The money is just there to grease the process, so bigger deals can get done."

The big statistic to note, he says, is that more than 50 percent of U.S. retail sales today go through franchised and licensed locations. And as retail sales grow, they will increase as a percentage of GDP.

"In the old days, being in the distribution side of the business had relatively thin margins, because we had distributors doing that. Today we have a more developed retail level. Today everybody realizes that if you want to get the real serious margins, you want to be all the way down at the retail level and delivering the goods. And that's where franchising has really done well."

Why restaurants?
"One of the biggest drivers today for private equity firms in franchising is restaurants," says Scott Pressley, a partner at Roark Capital Group. "Restaurants by far are the largest segment within franchising, and restaurants are very hot today in the context of investments."

In fact, says Pressley, there have been scores of restaurant transactions in the past 18 months, most by private equity firms. That is very different from five years ago, he says, "when the investment community hated restaurants."

Restaurants are cyclical, as are hotels, he says. "There are times when it's very attractive to be in restaurants. You see public offerings from restaurants. You're seeing a lot of cash flowing into the restaurant industry. Then there are times like five years ago when it was the opposite. You saw people going private; you saw very few restaurant transactions."

And while Roark has focused on majority investments in franchisors, other funds, especially smaller ones, are looking at the franchisee side-and what's "small" in the world of billion-dollar equity funds is serious money to even the larger area developers and multi-unit operators.

Exit strategy?
"The private equity people do all of a sudden have a keen interest in restaurants," says John Metz, president, RREMC, LLC, a multiple-unit franchisee of Denny's and Bennigan's. "I think it's only a matter of time before they step down into the large franchisee ranks and do some acquisitions there."

Metz says he and his partner have been able to grow his company "the old-fashioned way" (that is, without outside investors) for more than 15 years. And while he didn't need private equity money going in, he sees how it could be very useful getting out.

"I see it as a potential exit strategy for us," he says. In the past three to five years, Metz says he has seen little investor interest in restaurants, but things are looking up-which will allow him to sell some or all of his restaurants or restaurant holdings when he's ready, if the trend continues.

"I see it as a potential exit strategy for us," he says. "In the last 3 to 5 years, there's been virtually nobody financing restaurant operators. Sure you've got the traditional GEs, etc., but they've been pulling back. So to the extent that you do have this private equity coming in, I see an exit strategy where I didn't previously in the past couple of years. At least now I could go sell a group of my restaurants or my franchise holdings to somebody, now I know there's a guy out there that they can raise equity money."

And what would an investor want? "If we invested at the franchisee level, we would typically be looking for something that in five years gave us an annualized rate of return of 30 percent," says Sohlen. "We'd be pretty happy with that."

Another time for a larger franchisee to consider outside investors, is when the operation becomes too large to sell to other franchisees, and the franchisor will not buy it back, says David Kraeling, president of ProSource, a $500 million division of $6 billion flooring and carpeting giant CCA Global Partners. Using investor capital to grow the operation can actually improve a multi-unit owner's chances of selling it, he says (see "Patient Money").

Size Matters
Private equity firms come in different sizes, have different goals and philosophies, and focus on different parts of franchising, differentiated primarily by the size of the fund and the amount it chooses to invest in each transaction.

"Our fund is small, at $40 million," says Dave Shryock, general partner of SB Partners. "We come into play if someone needs $1 million to $5 million in equity." Typically that someone is a franchisee, rather than a franchisor.

"Often what we're doing is buying a group of franchise stores and then recruiting management to come in and run them for us," he says. "We're typically looking at [participating in] transactions that are $5 million to $15 million in size." Deals of that size usually mean dealing with a group of franchise stores rather than a franchisor, he says.

SB Partners did have one opportunity to invest in a franchisor, and did very well for its investors. In February 2004, the firm invested $3.9 million in Mississippi Restaurant Holdings (MRH), the franchisor of McAlister's Deli. The fund just happened to have the right amount of capital available at the time McAlister's needed it, says Shryock.

"Typically, a franchisor will need more capital than we have, so they'll find themselves going to a larger private equity fund." Not this time. Shryock joined the MRH board as a minority owner and remained there until July 2005, when SB Partners sold its stock for $10.6 million-nearly tripling its investment in fewer than 18 months.

SB Partners sold its McAlister's stock to Roark Capital Group. "We're kind of like Single-A ball; they're kind of like the major leagues," says Shryock, But there are bigger leagues still in the private equity food chain (see below).

Bigger Fish
Roark Capital Group likes franchises. In fact, Roark was founded by a former franchisor, Neal Aronson, who shifted from a career in private equity and investment banking to co-found U.S. Franchise Systems (USFS). In five years, USFS grew from a single brand with about two dozen hotels in nine states, to three brands and 1,100 hotels open or in development in 50 states and five countries. When it sold in 2000, USFS delivered a 269% internal rate of return to its private equity investors (5.5 times their equity investment).

Roark Capital also likes restaurants. In July, Roark acquired McAlister's Deli, its sixth franchise company. The acquisition was the first under its recently raised $413 million fund. Roark's other franchise acquisitions are Carvel, Money Mailer, FastSigns International, Cinnabon's, and Seattle's Best Coffee International.

"We've actually operated as a franchisor," says Pressley, who worked with Aronson as head of acquisition and development at USFS. "We think we have a little bit of understanding of the operations because we've done it for five years, versus just being a pure investor."

A typical equity investment for Roark ranges from $10 million to $150 million, in companies with revenues of $20 million to $1 billion. Unlike SB Partners, for example, Roark must be a majority investor in any company it considers.

When it comes to investments, "There's not a right or wrong; it's just what is your mandate as an investment firm," says Pressley. And for franchisees and franchisors exploring the possibility of an equity partner, it's important to find the right fit.

Each private equity fund also has its own investment philosophy and goals. At Roark, says Pressley, "We're looking for a management team that is excited about what they're doing, and is hungry and wants to grow the business." Then they work to support that management team in doing what it does best: operate the business. At McAlister's, for example, Phil Friedman, who was CEO at the time of purchase, continues to lead the company.

"We don't run the companies," says Pressley. "We want to give them the resources-whether it's financial to put in infrastructure, or active outside board members to sit around the table and bring ideas and provide perspectives to challenge the team, and to be a sounding board and a resource to them to help grow the business."

In addition to bringing complementary skills and perspectives, Roark likes to invest additional capital in its transactions, says Pressley. After acquiring Carvel, Roark purchased Cinnabon because it was a complementary concept that could bring improved results to both through co-branding.

"We've invested additional dollars in each one of our brands, whether it's in acquisitions, or in infrastructure or resources," says Pressley. "Our view is growth and investment. Our time horizons are not one to two years; these are 5- to 7-year investments for us. We want to invest, we want to give the management team the resources, we want to grow the franchise system."

Crazy like a chicken (and bigger still)
In late September, Trimaran Capital Partners agreed to purchase El Pollo Loco from American Securities Capital Partners, which bought the struggling concept in late 1999 from the Advantica Restaurant Group. The purchase price, though undisclosed, was approximately $400 million, according to the Los Angeles Times. Members of El Pollo Loco's management, led by CEO Steve Carley, will invest in the company and retain their current positions, said Andrew Heyer, Trimaran's managing partner. The purchase is expected to close in the fourth quarter.

Trimaran plans to continue the brand's national expansion from its base of 328 stores in southern California and the Southwest. The goal is to open 150 locations in the next five years in New York, New Jersey, New England, Chicago, Denver, and Texas. El Pollo Loco has signed franchise agreements for new stores in those markets, according to Heyer.

So why spend $400 million on "crazy chicken"? Will the brand's marinated flame-broiled chicken, which originated in Mexico, fly outside the Southwest? Trimaran is betting nearly half a billion it will.

"It's a proven concept with limited geography and a huge rollout potential," says Heyer. The brand is "hitting on all cylinders," he says: chicken as today's "protein of choice"; the Latin connection, where market growth is enormous; and, compared with most QSR food, El Pollo Loco's is in the "better-for-you" category, says Heyer. "The trends are friends."

The company's numbers aren't bad either, says Heyer: the average unit volume of the stores is "spectacular," and the return on investment to the franchisee is at the "very, very top of the industry." And as far as its competitive position in the market, the brand is in the "sweet spot" of having fast casual-quality food and the ability to deliver it in a QSR environment. "Fast casual is the fastest-growing part of the restaurant industry, but one of the real challenges in that business-to deliver quality food-is to deliver it quickly, or through a drive-through." Heyer says El Pollo Loco does both.

Money Matters
But let's come back to earth. The recent growth in private equity investments is not about franchising, nor is it about restaurants being the greatest thing since sliced bread (or flame-broiled chicken). As with all private equity deals, it comes down to the numbers. If franchises and restaurants happen to be in the sweet spot of private investors today, it's because their numbers are right and they promise a good return to investors compared with other deals.

"Premier brands, successful retail operations, attract private equity money, whether they're franchising or otherwise," says Heyer. "I think the appeal of franchising-either as a portion of a company's business or all of it-is obviously the nature of the revenue stream and the low capital expenditure component of being the franchisor."

El Pollo Loco is the first franchisor transaction in Trimaran's current fund. Its prior fund included an investment in Domino's. "Franchising is something we've been around for a while, either previously when we were investment bankers, or more recently as equity investors," says Heyer. Trimaran also owns Charlie Brown's restaurant chain of company-owned stores.

"It's not as much franchising per se as trying to find quality companies at a fair price," says Heyer. "Again, the primary driver of how we identify our investments is whether or not the company is fundamentally a good business, franchising or not."