Why Private Equity May Be the Preferred Vehicle for Franchise Expansion

Why is private equity funding the hottest thing in franchising today? In the past 12 months, private equity buyouts have included well-known brands such as Cinnabon, Church's Chicken, Taco Bueno (a regional taco maker), and regional frozen dessert operator Rita's Italian Ice.

In the last quarter of 2005, two huge transactions occupied the financial stories about franchising. First, Dunkin' Brands Inc., the umbrella company for the Dunkin' Donuts, Baskin Robbins and Togo's brands, was spun off by Pernod Richard, the French wine and spirits manufacturer, to raise money for its recent acquisition of British distiller Allied Domecq PLC. Dunkin' Brands was purchased for more than $2.4 billion by a consortium of equity firms Bain Capital Partners, the Carlyle Group, and Thomas H. Lee Partners. Second, Quiznos, the fastest-growing sandwich restaurant chain in the United States, hired Wall Street investment bank Goldman Sachs Group Inc. to find a buyer for the chain.

These deals may only be the beginning of the food industry consolidation of franchise companies. Private equity firms are heating up the restaurant and franchise sectors, increasing the multiples for pricing. Restaurants and franchise companies have predictable cash flow, which can be improved by cost cutting. Many private equity firms or hedge funds are flush with cash. They can inject much-needed capital into mature concepts by updating the image of the concepts and investing in expensive market research. As franchisors mature and competition increases, the companies that act on the results of market research will have the competitive edge.

Alternatively, many new franchisors are not candidates for hedge fund investment, but they can find financing from private equity investors. Unlike hedge funds, which sometimes need to show profits from quarter to quarter, private equity investors typically are more patient, looking at least at 3-year time horizons, and typically 5 to 6 years before a liquidity event.

Some private equity firms see acquisition as a cheap way of acquiring undervalued real estate in a franchisor's portfolio. In the 1980s, Dunkin' Donuts Incorporated had a large undervalued real estate portfolio and was publicly held. To its surprise, the company became an unwelcome takeover target until acquired by a white knight investor, Allied Lyons, which took the company private. Now, that real estate contributed to the reported $2.4 billion price tag for the company.

History might be repeated with McDonald's, as private equity investor William Ackerman has called on McDonald's to spin off 20% of its company-owned units. McDonald's Corporation historically has developed its own real estate even for franchised units and operates a significant portion of its locations under company ownership. These company-owned stores have increased in value not only because of increased profitability, but also because of real estate appreciation. The spin off of the company operations would be a liquidity event for existing McDonald's shareholders who would reap large dividends from the sale of the undervalued units.

Most private equity buyouts are targeted, however, to acquiring a franchise concept as a platform for further growth. The restaurant sector is where the high-profile transactions are occurring, yet similar transactions are occurring in other franchise sectors and industries without the same fanfare. Private equity transactions are becoming more popular for going-private transactions, even in the real estate investment trust (“REIT”) arena.

Private equity funds have some advantages that can be beneficial to the acquired franchisor and its franchisees. In addition to the longer-term investment perspective, private equity firms can turn the company on a dime without expensive and time-consuming proxy battles and securities lawsuits (as compared to buyouts funded with public funds). Transactional costs can be significantly lower with private equity investors than through raising capital in public markets.

When private equity is leveraged with franchisee investments into expansion, the projected growth is exponential, which may help explain the large multiples seen in the acquisition of franchised companies compared to other companies selling the same products and services. These private equity companies also have learned from the dot-com boom and know that in this capital environment, 30% compounded returns per year with 3-year exit strategies may not be realistic and may even be counterproductive. Still, these buyout firms with large sources of capital are increasing valuations and pricing.

Quiznos, the fastest-growing sandwich restaurant chain in the United States, is a good example of what is taking place today. In November 2005, Rick Schaden and his father Dick, former franchisees who took Quiznos private in 1991, announced that Goldman Sachs is seeking a buyer for the chain. They are hoping for a sales price at 11 to 17 times earnings, which could raise bidding to the $2 billion mark. Preliminary offers began arriving in January 2006.

Quiznos is growing at an annual pace of about 30%, has chain-wide sales through franchisees of about $1.3 billion, and annual earnings of $135 million. Quiznos has about 3600 stores in the United States and has proven its concept by opening 400 in foreign countries.

Although dwarfed by Subway, which has about 21,000 locations, Quiznos has differentiated itself by offering toasted sandwiches and quirky television advertising. Subway, in response, is beefing up its television advertising and now adding toaster ovens at all of its locations to address the Quiznos “Mmmm Toasty!” campaign. Not surprisingly, Blimpie's International, the third-largest sandwich chain, not too long ago had a significant private equity investment, and it is rumored to be looking at another private equity investor.

The multiple that Quiznos is aiming for seems a little rich compared with the price of other established restaurant franchisors, such as Dunkin' Brands. Granted, Dunkin' Donuts is more mature, but it's still growing, and it has more than twice the sales and number of outlets. Quiznos points out that it's growing faster: Quiznos opened 800 units last year and has commitments to open another 1700 units.

Yet growth is a double-edged sword. Quiznos franchisees have claimed that they struggle to make money because of high food costs, lack of corporate support, and encroachment of competing Quiznos. A Canadian franchisee filed a proposed class action case in Ontario, claiming that Quiznos is taking deposits for locations that take too long to open, or will never open. Under the Quiznos franchise agreement, the locations are required to be opened in one year, and according to the lawsuit, many in Canada have not opened within that year and are on extension. Lawsuits by franchisees when the franchisor is on the block are not particularly uncommon, and the franchisees may be offered settlement options in some cases to help the transaction conclude.

What Is the Franchisor's Attorney's Role?

The private equity players are sophisticated and aggressively seek investment opportunities. If you are counsel to a franchisor that has not yet been approached, you should attend conferences on restaurant and franchise finance, as well as multi-unit operator conferences, to familiarize yourself with the needs and the mindset of private equity players. All financiers look at certain financial metrics to evaluate opportunities. You should educate your clients to look at the same metrics to benchmark their company against others in the competition for financing.

Also, a franchise system is only as marketable as its legal underpinnings. If the system has unresolved conflict and poor documentation, many inves-tors will not invest the time to sift through the diligence necessary to make an informed decision. Too many deals are available now, and private equity players can afford to be selective. The franchisor's attorney's role can be best summarized as getting the franchisor in compliance and ready for an examination. Documents and systems should be streamlined so the diligence will be streamlined. Business challenges should be identified and ready to be discussed to determine whether these challenges create barriers to acquisition. If the barriers can be overcome with additional capital, this is a prime opportunity for a strategic investor and can be the basis of a win-win buyout based on future performance.

Opportunity Knocks

In this environment, even new franchisors are successfully raising capital for roll-ups and start-ups by private placements. The private placements use the larger companies in the industry to validate the business model and benchmark the valuations.

Even new franchisors and larger franchisees can get in the game. New franchisors can simultaneously prepare a franchise program and a private placement to fund expansion within 90-day windows, and the securities firms are happy to market these programs. Private equity investors are looking to fund large multi-unit operators, which increases the number and quality of outlets at the franchisee level. Some private equity investors fund the operators in order to gain a window to the inside workings of the franchisor, and are poised to position themselves for acquisition when the founders are ready to convert their brand equity to cash.

Merger and acquisition activity is on the rise, as if the players were heeding the advice, “When they are giving out money, get in line.” Investors are unlocking hidden equity in companies that have not yet outgrown their comfort zone for expansion and innovation. Franchisors and franchisees see new sources of capital through private equity and private placements. Private equity and hedge fund investment are here to stay, and for very good reasons.

Why is private equity funding the hottest thing in franchising today? In the past 12 months, private equity buyouts have included well-known brands such as Cinnabon, Church's Chicken, Taco Bueno (a regional taco maker), and regional frozen dessert operator Rita's Italian Ice.

In the last quarter of 2005, two huge transactions occupied the financial stories about franchising. First, Dunkin' Brands Inc., the umbrella company for the Dunkin' Donuts, Baskin Robbins and Togo's brands, was spun off by Pernod Richard, the French wine and spirits manufacturer, to raise money for its recent acquisition of British distiller Allied Domecq PLC. Dunkin' Brands was purchased for more than $2.4 billion by a consortium of equity firms Bain Capital Partners, the Carlyle Group, and Thomas H. Lee Partners. Second, Quiznos, the fastest-growing sandwich restaurant chain in the United States, hired Wall Street investment bank Goldman Sachs Group Inc. to find a buyer for the chain.

These deals may only be the beginning of the food industry consolidation of franchise companies. Private equity firms are heating up the restaurant and franchise sectors, increasing the multiples for pricing. Restaurants and franchise companies have predictable cash flow, which can be improved by cost cutting. Many private equity firms or hedge funds are flush with cash. They can inject much-needed capital into mature concepts by updating the image of the concepts and investing in expensive market research. As franchisors mature and competition increases, the companies that act on the results of market research will have the competitive edge.

Alternatively, many new franchisors are not candidates for hedge fund investment, but they can find financing from private equity investors. Unlike hedge funds, which sometimes need to show profits from quarter to quarter, private equity investors typically are more patient, looking at least at 3-year time horizons, and typically 5 to 6 years before a liquidity event.

Some private equity firms see acquisition as a cheap way of acquiring undervalued real estate in a franchisor's portfolio. In the 1980s, Dunkin' Donuts Incorporated had a large undervalued real estate portfolio and was publicly held. To its surprise, the company became an unwelcome takeover target until acquired by a white knight investor, Allied Lyons, which took the company private. Now, that real estate contributed to the reported $2.4 billion price tag for the company.

History might be repeated with McDonald's, as private equity investor William Ackerman has called on McDonald's to spin off 20% of its company-owned units. McDonald's Corporation historically has developed its own real estate even for franchised units and operates a significant portion of its locations under company ownership. These company-owned stores have increased in value not only because of increased profitability, but also because of real estate appreciation. The spin off of the company operations would be a liquidity event for existing McDonald's shareholders who would reap large dividends from the sale of the undervalued units.

Most private equity buyouts are targeted, however, to acquiring a franchise concept as a platform for further growth. The restaurant sector is where the high-profile transactions are occurring, yet similar transactions are occurring in other franchise sectors and industries without the same fanfare. Private equity transactions are becoming more popular for going-private transactions, even in the real estate investment trust (“REIT”) arena.

Private equity funds have some advantages that can be beneficial to the acquired franchisor and its franchisees. In addition to the longer-term investment perspective, private equity firms can turn the company on a dime without expensive and time-consuming proxy battles and securities lawsuits (as compared to buyouts funded with public funds). Transactional costs can be significantly lower with private equity investors than through raising capital in public markets.

When private equity is leveraged with franchisee investments into expansion, the projected growth is exponential, which may help explain the large multiples seen in the acquisition of franchised companies compared to other companies selling the same products and services. These private equity companies also have learned from the dot-com boom and know that in this capital environment, 30% compounded returns per year with 3-year exit strategies may not be realistic and may even be counterproductive. Still, these buyout firms with large sources of capital are increasing valuations and pricing.

Quiznos, the fastest-growing sandwich restaurant chain in the United States, is a good example of what is taking place today. In November 2005, Rick Schaden and his father Dick, former franchisees who took Quiznos private in 1991, announced that Goldman Sachs is seeking a buyer for the chain. They are hoping for a sales price at 11 to 17 times earnings, which could raise bidding to the $2 billion mark. Preliminary offers began arriving in January 2006.

Quiznos is growing at an annual pace of about 30%, has chain-wide sales through franchisees of about $1.3 billion, and annual earnings of $135 million. Quiznos has about 3600 stores in the United States and has proven its concept by opening 400 in foreign countries.

Although dwarfed by Subway, which has about 21,000 locations, Quiznos has differentiated itself by offering toasted sandwiches and quirky television advertising. Subway, in response, is beefing up its television advertising and now adding toaster ovens at all of its locations to address the Quiznos “Mmmm Toasty!” campaign. Not surprisingly, Blimpie's International, the third-largest sandwich chain, not too long ago had a significant private equity investment, and it is rumored to be looking at another private equity investor.

The multiple that Quiznos is aiming for seems a little rich compared with the price of other established restaurant franchisors, such as Dunkin' Brands. Granted, Dunkin' Donuts is more mature, but it's still growing, and it has more than twice the sales and number of outlets. Quiznos points out that it's growing faster: Quiznos opened 800 units last year and has commitments to open another 1700 units.

Yet growth is a double-edged sword. Quiznos franchisees have claimed that they struggle to make money because of high food costs, lack of corporate support, and encroachment of competing Quiznos. A Canadian franchisee filed a proposed class action case in Ontario, claiming that Quiznos is taking deposits for locations that take too long to open, or will never open. Under the Quiznos franchise agreement, the locations are required to be opened in one year, and according to the lawsuit, many in Canada have not opened within that year and are on extension. Lawsuits by franchisees when the franchisor is on the block are not particularly uncommon, and the franchisees may be offered settlement options in some cases to help the transaction conclude.

What Is the Franchisor's Attorney's Role?

The private equity players are sophisticated and aggressively seek investment opportunities. If you are counsel to a franchisor that has not yet been approached, you should attend conferences on restaurant and franchise finance, as well as multi-unit operator conferences, to familiarize yourself with the needs and the mindset of private equity players. All financiers look at certain financial metrics to evaluate opportunities. You should educate your clients to look at the same metrics to benchmark their company against others in the competition for financing.

Also, a franchise system is only as marketable as its legal underpinnings. If the system has unresolved conflict and poor documentation, many inves-tors will not invest the time to sift through the diligence necessary to make an informed decision. Too many deals are available now, and private equity players can afford to be selective. The franchisor's attorney's role can be best summarized as getting the franchisor in compliance and ready for an examination. Documents and systems should be streamlined so the diligence will be streamlined. Business challenges should be identified and ready to be discussed to determine whether these challenges create barriers to acquisition. If the barriers can be overcome with additional capital, this is a prime opportunity for a strategic investor and can be the basis of a win-win buyout based on future performance.

Opportunity Knocks

In this environment, even new franchisors are successfully raising capital for roll-ups and start-ups by private placements. The private placements use the larger companies in the industry to validate the business model and benchmark the valuations.

Even new franchisors and larger franchisees can get in the game. New franchisors can simultaneously prepare a franchise program and a private placement to fund expansion within 90-day windows, and the securities firms are happy to market these programs. Private equity investors are looking to fund large multi-unit operators, which increases the number and quality of outlets at the franchisee level. Some private equity investors fund the operators in order to gain a window to the inside workings of the franchisor, and are poised to position themselves for acquisition when the founders are ready to convert their brand equity to cash.

Merger and acquisition activity is on the rise, as if the players were heeding the advice, “When they are giving out money, get in line.” Investors are unlocking hidden equity in companies that have not yet outgrown their comfort zone for expansion and innovation. Franchisors and franchisees see new sources of capital through private equity and private placements. Private equity and hedge fund investment are here to stay, and for very good reasons.