Impact of Private Equity on Franchising

In 2012 alone, our firm has worked on eight private equity deals, mostly on the buyer side, and we sponsored two private equity conferences in New York. The most interesting thing we've seen is how private equity has learned to zero-in on the real value factors in franchise systems ' unit-level economics and the quality of the franchise relationships. One deal blew up because the fund could not get comfortable with the brand's largest franchisee. Has it affected franchising? I would venture to say that it's the most influential force in franchising today.

Benefits Include Greater Experimentation

Craig Tractenberg, Nixon Peabody LLP

I believe that investments which keep franchise companies private benefit the companies and their consumers. Public companies are compelled to meet earnings calendar earnings targets to satisfy their many investors. Public companies will play to the analysts to meet those targets and engineer their balance sheets. Private companies need only satisfy a smaller number of investors, allowing more daring and diverse strategies executed in the privacy. Mistakes are allowed and are not magnified in the media with private companies ' which allows for greater experimentation.

Equity Firms Possibly Become Franchisors

Gregg Rubenstein, Nixon Peabody LLP

I think this trend reflects the maturing of franchising as a business model. While there are still plenty of examples of someone creating a business and then deciding to grow that business through franchising, I believe it will become less common going forward. Instead, we will see venture capital funds actively looking for new business concepts that they buy and then use their expertise to franchise. The switch from business concept to franchisor has traditionally been difficult, but this should make the failure rate go down as “professional” franchisors become more common. The downside is that it will also make it more difficult for small-business concepts to franchise, as the professionally driven companies will likely present a more compelling picture to prospective franchisees than the smaller mom-and-pop systems.

More Capital and Sophistication

Peter Silverman, Shumaker, Loop & Kendrick, LLP

There's a fear that equity players will seek to buy-and-flip franchises by taking short-term steps to improve net and gross numbers in ways that hurt franchisees (e.g., higher fees, higher rebates, lower service, lower direct advertising, aggressive remodel requirements) or the system (e.g., lower standards for bringing in new franchisees). I've seen some of this, but my guess is that it will soon be the exception rather than the rule. A short-term focus in franchising is destructive; firms that try it will soon figure out that they're just digging a hole that will take a lot of time, capital and vision from which to dig out. The only buyers they'll be able to flip to will be turn-around buyers looking to buy at a steep discount.

If equity buyers do become longer-term players, I think the development will be very healthy for franchising. It offers capital and sophistication to franchisors and multi-unit franchisee owners looking for partners or to exit.

Another consideration is that franchising as a business model is young. The entrepreneur who builds the system doesn't necessarily have the skills to maintain it or take it to the next level. Over time, a strong successor-ownership model will evolve, and I'd expect that equity investors would play a dominant role in that model.

Tougher Scrutiny from Demanding Investors

Joel R. Buckberg, Baker, Donelson, Bearman, Caldwell & Berkowitz, PC

Private equity funds and other institutional investors have been investing in franchisors since franchising's early days. They have always recognized and rewarded the predictable cash flow, scalable growth models, and high margins. What's different is the growth path. Private equity used to be a waypoint on the road to public-company status. Today, as fewer franchisors decide to go public, private equity ownership has supplanted public company financial models. Public franchisors were and are largely owned by institutions. The same institutions now invest through private equity vehicles, but the private equity fund managers are tougher on franchisor management than the public investor oversight world. They have less flexibility and more aggressive growth targets that push the limits of how far and how fast a brand can grow. That's where the difference lies.

Pros and Cons

Leonard Vines, Greensfelder, Hemker, & Gale, P.C.

The increasing control of franchise systems by investment groups has affected franchising both positively and negatively. On the positive side, since these groups provide owners a vehicle for succession and exit planning, franchising as a business model may become more desirable as investors can see a way to cash out. Conceivably, some of those who sell will devote funds to develop new, innovative concepts.

In addition to providing necessary funds for expansion, private equity groups can bring skilled expertise and a high level of sophistication. Cost-cutting measures and improved efficiencies, along with the opportunity to forge new relationships, can enhance the value of the system. The franchise can become more competitive and profitable and thereby focus on growth and innovation without the looming cloud of financial pressures. Opportunities to expand both nationally and internationally also can help the overall economy and create more jobs.

On the negative side, however, there is a risk that the culture of the franchise will change for the worse. Franchisees who once felt they were part of a benevolent “family” may feel like employees or “just a number” with little control over their destiny. If the culture changes too dramatically, many franchisees could become unhappy, which is bad not only for the system, but for franchising in general. Finally, some franchisors simply are not prepared to give up control and are not willing to accept the inevitable changes that will be made to their system.

Managing Competing Priorities

Rupert Barkoff, Kilpatrick Town-send & Stockton LLP

Private equity and venture capital funds can create interesting situations when they purchase interests in franchise system. There are at least two reasons why I say this:

First, their economic interests may be focused differently than those of the franchisees. Franchisees are in for the long haul. Investors in the franchisor typically have a shorter focus. They are more interested in what return they can earn for their investors in the short haul ' perhaps three to seven years. Historical loyalty of the employees becomes less important as the new owners ask, “What have you done lately?” Culture is not as important as cash.

And that brings me to my second point. Those who purchase franchise systems do not often fully appreciate the role that franchisor-franchisee relationships play. While the franchise agreement will almost always give the thumb on the scale to the franchisor, the power that the franchisor can exercise over the franchisees is not unlimited. Franchisors typically want existing franchisees to buy more units; happy franchisees help sell franchises to outsiders. Bad-mouthing can severely damage franchise sales.

System change is not all bad. When it clearly adds to the franchisees' bottom line, it will be better received. But life seems to favor inertia rather than change. And change can often lead to the departure of long-time friends from management. A franchisor should never underestimate how important the goodwill of the franchisees can be in contributing to success.

Growth Is the Game

Jeff Baker, Burr & Forman LLP

Most franchise systems were originally built around the concept of personal investment by individual entrepreneurs who would run the franchised business as an owner/operator. Access to capital and other factors tended to keep growth rates moderate. Once franchisees started becoming large enough to attract investment by private equity funds and similar investors, we began to see a shift in the power dynamic between franchisee and franchisor. Private equity funds have the ability to put together complex capital structures that enable rapid growth, and growth is their game. In response to the potential economic threat posed by a system of very large franchisees run by investors rather than owner/operators, some franchisors have started to implement size limits on their franchisees.

Private equity funds generally prefer not to hold real estate in their portfolio companies because fee-owned real estate presents risk and valuation issues that can be difficult to quantify when calculating the fund's projected return on investment. As a result, many franchisees have found themselves in the position of pushing their operating properties into the sale-leaseback market in order to posture the business for sale. Careful attention must be paid to the assignment and change-of-control provisions embedded in such leases in order to make certain that the sale-leaseback landlord does not obtain unreasonable control rights that could limit the franchisee's ability to sell to a private equity fund or, more importantly, limit the private equity fund's exit strategy on the next turn of the company.

New Sources of Capital and Expertise

Frank Zaid, Osler, Hoskin & Harcourt LLP

The acquisition of control of franchise systems by private equity funds, venture capital funds and other types of investment groups (“investment funds”) has clearly affected franchising.

First, as a result of the continuing recession, franchisors have been denied access to traditional sources of capital for system development and operations growth. Similarly, traditional lenders have withdrawn franchisee financing programs. The net result is that more franchisors lack capital resources to grow their systems, and fewer franchisee candidates can access funds to purchase franchises. Investment funds can bypass these problems by injecting funds into the franchise system and by creating more flexible franchisee financing programs.

Second, many franchise systems have reached maximum management expertise and require new investment and strategic direction for the next stage of development. In some cases, the owners are ready for succession or retirement, but do not have qualified successors. An investment fund can structure an exit strategy but also retain the owners as employees or consultants for a period of time. Franchisees will appreciate the continuity and gradual transition.

Third, investment funds often introduce new management systems, controls and reporting standards that reduce costs, improve efficiencies and enhance franchise value. While more stringent controls over franchisees may lead to some unrest, compliant franchisees usually benefit from a more tightly controlled operation.

In an era of negative growth for many franchise systems, acquisitions by investment funds have provided exits for struggling owners and relief for floundering franchisees. As in so many other business situations, timing is everything.

Change Coming for Franchisees

Gaylen Knack, Gray Plant Mooty

The invasion of private equity and other investment funds into the world of franchising has had a significant impact. While the impact has been widespread, private equity (and similar funding) mechanisms have altered the franchising landscape in three significant ways. First, it has provided a possible exit strategy for family or closely owned franchisors and some multi-unit franchisees, many of whom spent years building their businesses. Without private equity, these owners would struggle to find a successor inside or outside the family. Second, healthy prices currently being offered for franchise systems have increased pressure on buyers to improve efficiencies and drive revenue. Private equity funds with seasoned management are adept at handling these pressures while maintaining good rapport with the system's franchisees. Private equity groups new to franchising, however, may not grasp the sometimes fickle relationship with franchisees and make short-sighted decisions that alienate franchisees. Finally, as private equity and other investment funds become more active in franchising, franchisees more likely will be confronted with change. Their reaction to this environment of change likely will lead to closer scrutiny of franchisor initiatives as well as provisions in the franchise agreement that grant the franchisor discretion to implement these initiatives.

Loyalty to Fund Investors Is Third Dimension

Rochelle “Shelley” Spandorf, Davis Wright Tremaine LLP

As private equity investors pour billions of dollars into franchise companies, the overall news is good for franchising. Of course, nothing is absolute. Not all franchisees see their outcomes improve after a PE fund acquires their franchisor, not all funds do their homework and properly size up the franchise system's culture or competitive challenges before investing, and not all fund managers appreciate the difficulty of leading a collective of independent owners. But, on balance, PE funds offer system members opportunities they would otherwise never enjoy. They bring credibility to a franchise system by publicly expressing faith in the brand and capital to fund system expansion. While funds may be less tolerant of underperforming franchisees and focused on cost-savings, these measures help build brand value, attract sophisticated franchisee candidates and improve the resale market for franchise units.

No doubt, having a PE fund steward the brand adds a third dimension to the franchise paradigm: loyalty to fund investors. But professional fund managers are smart and, as they become more experienced operating franchise companies, they better appreciate the interdependence between their own and their franchisees' profitability. Funds today also invest heavily in multi-unit franchisees and understand franchising from both sides of the aisle.

What PE fund ownership may signal is that there is no longer room for “moms and pops” within the system's rank and file. System growth through “corporate” multi-unit franchisees may mean a seismic cultural shift for some franchise systems. PE funds that are insensitive to this cultural dynamic may be unprepared for managing the human element of franchising.

Franchisors Should Move Cautiously

Earsa R. Jackson, Strasburger & Price, LLP

The increasing presence of private equity funds in the franchise arena has its benefits as well as challenges. Private equity can be a godsend for a company ripe for expansion that does not have the capital to expand. Because private equity funds are so geared toward business and the bottom line, they can be useful in helping franchise systems trim down where necessary and cleaning up any loose ends on operations.

Depending on the degree to which the private equity fund involves itself in the operation of the core business, a franchise system may find that its corporate culture changes. I have heard franchise executives talk about difficulties with maintaining their own corporate identity once private equity comes to the table. Like every deal, the devil is in the details. Not all deals are created equal, just like not all private equity funds are created equal. A franchisor should take its time during the “courtship” phase to get to know the private fund before it jumps into bed with a stranger who might ultimately be calling the shots.

Positive Impact

Matthew Kreutzer, Armstrong Tea-sdale LLP

I think the influx of private money has affected franchising in a positive way. The private equity funds I have encountered have largely taken a “hands off” approach to management, being content to leave in place the leadership structure that has brought the franchisor to their attention. That said, the fund managers are not disinterested. Wanting to protect their investment, they closely monitor the franchisor. The franchisor's executives (many who owned their companies outright prior to the third-party investment) are faced with having to answer to a third party for their decisions, which generally results in increased efficiency and reduced expenses across the board. At the same time, these outside investors are important to the acquired franchisor, as they provide access to much-needed capital. The influx of money carries with it a number of benefits, allowing the franchisor to improve its infrastructure and to grow its system. As the system grows, franchisee businesses also tend to grow and improve with it.

Bottom-Line PerspectiveExtends to Litigation

Jeffrey Fillerup, McKenna Long & Aldridge, LLP

Private equity has generally had a favorable view of expected litigation/dispute resolution costs and problems in franchising, and this has made the investment in franchise businesses more attractive. From the perspective of potential investors, franchise businesses tend to have a favorable litigation track record, a positive franchisor-franchisee relationship history, and a relatively nominal amount of litigation and disputes relative to the revenues generated. On the downside, equity investors are not as enthusiastic about some of the litigation-related features of franchise businesses, such as franchisors' inability to have complete decision-making control over the entire system, which can sometimes lead to franchisor-franchisee conflicts.

When private equity has invested in a franchise businesses, on the franchisor or franchisee side, it has had a net positive impact on franchising. Private equity tends to have sophisticated and experienced management in all aspects of business, including litigation and dispute resolution, leading to common-practice litigation management. Litigation directed by private equity tends to be bottom-line driven, which is typical of litigation in other businesses, and there tends to be a broader perspective in connection with resolution of disputes and settlement of litigation. However, there are aspects of franchising that private equity has been less able to calculate in the dispute-resolution equation. Private equity [management] typically will not have experience with contentious franchisees and franchisee associations, whom they are forced to deal with because they cannot simply terminate problem groups or individuals as they can in other businesses. Private equity also has difficulty with some of franchising's unique issues, such as franchisees' exclusive territories, and finding a clear path to both overall system growth while avoiding franchisee encroachment complaints.

As 2013 begins, franchising is being transformed by major investments in franchise systems by private equity funds. FBLA asked leading franchise attorneys how they see private equity affecting the industry, and their responses reflect widespread optimism that these investors are bringing much more than (the widely appreciated) funding that can fuel franchise expansion. With their focus on investor returns, private equity investors can help franchises to define their strategies more carefully and to be relentless in seeking to improve profitability. However, these benefits come at the price of a loss of independence that can be especially hard for founders of franchise systems who have accepted private equity ownership.

Most Influential Force in Franchising Today

David Koch, Plave Koch PLC

In 2012 alone, our firm has worked on eight private equity deals, mostly on the buyer side, and we sponsored two private equity conferences in New York. The most interesting thing we've seen is how private equity has learned to zero-in on the real value factors in franchise systems ' unit-level economics and the quality of the franchise relationships. One deal blew up because the fund could not get comfortable with the brand's largest franchisee. Has it affected franchising? I would venture to say that it's the most influential force in franchising today.

Benefits Include Greater Experimentation

Craig Tractenberg, Nixon Peabody LLP

I believe that investments which keep franchise companies private benefit the companies and their consumers. Public companies are compelled to meet earnings calendar earnings targets to satisfy their many investors. Public companies will play to the analysts to meet those targets and engineer their balance sheets. Private companies need only satisfy a smaller number of investors, allowing more daring and diverse strategies executed in the privacy. Mistakes are allowed and are not magnified in the media with private companies ' which allows for greater experimentation.

Equity Firms Possibly Become Franchisors

Gregg Rubenstein, Nixon Peabody LLP

I think this trend reflects the maturing of franchising as a business model. While there are still plenty of examples of someone creating a business and then deciding to grow that business through franchising, I believe it will become less common going forward. Instead, we will see venture capital funds actively looking for new business concepts that they buy and then use their expertise to franchise. The switch from business concept to franchisor has traditionally been difficult, but this should make the failure rate go down as “professional” franchisors become more common. The downside is that it will also make it more difficult for small-business concepts to franchise, as the professionally driven companies will likely present a more compelling picture to prospective franchisees than the smaller mom-and-pop systems.

More Capital and Sophistication

Peter Silverman, Shumaker, Loop & Kendrick, LLP

There's a fear that equity players will seek to buy-and-flip franchises by taking short-term steps to improve net and gross numbers in ways that hurt franchisees (e.g., higher fees, higher rebates, lower service, lower direct advertising, aggressive remodel requirements) or the system (e.g., lower standards for bringing in new franchisees). I've seen some of this, but my guess is that it will soon be the exception rather than the rule. A short-term focus in franchising is destructive; firms that try it will soon figure out that they're just digging a hole that will take a lot of time, capital and vision from which to dig out. The only buyers they'll be able to flip to will be turn-around buyers looking to buy at a steep discount.

If equity buyers do become longer-term players, I think the development will be very healthy for franchising. It offers capital and sophistication to franchisors and multi-unit franchisee owners looking for partners or to exit.

Another consideration is that franchising as a business model is young. The entrepreneur who builds the system doesn't necessarily have the skills to maintain it or take it to the next level. Over time, a strong successor-ownership model will evolve, and I'd expect that equity investors would play a dominant role in that model.

Tougher Scrutiny from Demanding Investors

Joel R. Buckberg, Baker, Donelson, Bearman, Caldwell & Berkowitz, PC

Private equity funds and other institutional investors have been investing in franchisors since franchising's early days. They have always recognized and rewarded the predictable cash flow, scalable growth models, and high margins. What's different is the growth path. Private equity used to be a waypoint on the road to public-company status. Today, as fewer franchisors decide to go public, private equity ownership has supplanted public company financial models. Public franchisors were and are largely owned by institutions. The same institutions now invest through private equity vehicles, but the private equity fund managers are tougher on franchisor management than the public investor oversight world. They have less flexibility and more aggressive growth targets that push the limits of how far and how fast a brand can grow. That's where the difference lies.

Pros and Cons

Leonard Vines, Greensfelder, Hemker, & Gale, P.C.

The increasing control of franchise systems by investment groups has affected franchising both positively and negatively. On the positive side, since these groups provide owners a vehicle for succession and exit planning, franchising as a business model may become more desirable as investors can see a way to cash out. Conceivably, some of those who sell will devote funds to develop new, innovative concepts.

In addition to providing necessary funds for expansion, private equity groups can bring skilled expertise and a high level of sophistication. Cost-cutting measures and improved efficiencies, along with the opportunity to forge new relationships, can enhance the value of the system. The franchise can become more competitive and profitable and thereby focus on growth and innovation without the looming cloud of financial pressures. Opportunities to expand both nationally and internationally also can help the overall economy and create more jobs.

On the negative side, however, there is a risk that the culture of the franchise will change for the worse. Franchisees who once felt they were part of a benevolent “family” may feel like employees or “just a number” with little control over their destiny. If the culture changes too dramatically, many franchisees could become unhappy, which is bad not only for the system, but for franchising in general. Finally, some franchisors simply are not prepared to give up control and are not willing to accept the inevitable changes that will be made to their system.

Managing Competing Priorities

Rupert Barkoff, Kilpatrick Town-send & Stockton LLP

Private equity and venture capital funds can create interesting situations when they purchase interests in franchise system. There are at least two reasons why I say this:

First, their economic interests may be focused differently than those of the franchisees. Franchisees are in for the long haul. Investors in the franchisor typically have a shorter focus. They are more interested in what return they can earn for their investors in the short haul ' perhaps three to seven years. Historical loyalty of the employees becomes less important as the new owners ask, “What have you done lately?” Culture is not as important as cash.

And that brings me to my second point. Those who purchase franchise systems do not often fully appreciate the role that franchisor-franchisee relationships play. While the franchise agreement will almost always give the thumb on the scale to the franchisor, the power that the franchisor can exercise over the franchisees is not unlimited. Franchisors typically want existing franchisees to buy more units; happy franchisees help sell franchises to outsiders. Bad-mouthing can severely damage franchise sales.

System change is not all bad. When it clearly adds to the franchisees' bottom line, it will be better received. But life seems to favor inertia rather than change. And change can often lead to the departure of long-time friends from management. A franchisor should never underestimate how important the goodwill of the franchisees can be in contributing to success.

Growth Is the Game

Jeff Baker, Burr & Forman LLP

Most franchise systems were originally built around the concept of personal investment by individual entrepreneurs who would run the franchised business as an owner/operator. Access to capital and other factors tended to keep growth rates moderate. Once franchisees started becoming large enough to attract investment by private equity funds and similar investors, we began to see a shift in the power dynamic between franchisee and franchisor. Private equity funds have the ability to put together complex capital structures that enable rapid growth, and growth is their game. In response to the potential economic threat posed by a system of very large franchisees run by investors rather than owner/operators, some franchisors have started to implement size limits on their franchisees.

Private equity funds generally prefer not to hold real estate in their portfolio companies because fee-owned real estate presents risk and valuation issues that can be difficult to quantify when calculating the fund's projected return on investment. As a result, many franchisees have found themselves in the position of pushing their operating properties into the sale-leaseback market in order to posture the business for sale. Careful attention must be paid to the assignment and change-of-control provisions embedded in such leases in order to make certain that the sale-leaseback landlord does not obtain unreasonable control rights that could limit the franchisee's ability to sell to a private equity fund or, more importantly, limit the private equity fund's exit strategy on the next turn of the company.

New Sources of Capital and Expertise

Frank Zaid, Osler, Hoskin & Harcourt LLP

The acquisition of control of franchise systems by private equity funds, venture capital funds and other types of investment groups (“investment funds”) has clearly affected franchising.

First, as a result of the continuing recession, franchisors have been denied access to traditional sources of capital for system development and operations growth. Similarly, traditional lenders have withdrawn franchisee financing programs. The net result is that more franchisors lack capital resources to grow their systems, and fewer franchisee candidates can access funds to purchase franchises. Investment funds can bypass these problems by injecting funds into the franchise system and by creating more flexible franchisee financing programs.

Second, many franchise systems have reached maximum management expertise and require new investment and strategic direction for the next stage of development. In some cases, the owners are ready for succession or retirement, but do not have qualified successors. An investment fund can structure an exit strategy but also retain the owners as employees or consultants for a period of time. Franchisees will appreciate the continuity and gradual transition.

Third, investment funds often introduce new management systems, controls and reporting standards that reduce costs, improve efficiencies and enhance franchise value. While more stringent controls over franchisees may lead to some unrest, compliant franchisees usually benefit from a more tightly controlled operation.

In an era of negative growth for many franchise systems, acquisitions by investment funds have provided exits for struggling owners and relief for floundering franchisees. As in so many other business situations, timing is everything.

Change Coming for Franchisees

Gaylen Knack, Gray Plant Mooty

The invasion of private equity and other investment funds into the world of franchising has had a significant impact. While the impact has been widespread, private equity (and similar funding) mechanisms have altered the franchising landscape in three significant ways. First, it has provided a possible exit strategy for family or closely owned franchisors and some multi-unit franchisees, many of whom spent years building their businesses. Without private equity, these owners would struggle to find a successor inside or outside the family. Second, healthy prices currently being offered for franchise systems have increased pressure on buyers to improve efficiencies and drive revenue. Private equity funds with seasoned management are adept at handling these pressures while maintaining good rapport with the system's franchisees. Private equity groups new to franchising, however, may not grasp the sometimes fickle relationship with franchisees and make short-sighted decisions that alienate franchisees. Finally, as private equity and other investment funds become more active in franchising, franchisees more likely will be confronted with change. Their reaction to this environment of change likely will lead to closer scrutiny of franchisor initiatives as well as provisions in the franchise agreement that grant the franchisor discretion to implement these initiatives.

Loyalty to Fund Investors Is Third Dimension

Rochelle “Shelley” Spandorf, Davis Wright Tremaine LLP

As private equity investors pour billions of dollars into franchise companies, the overall news is good for franchising. Of course, nothing is absolute. Not all franchisees see their outcomes improve after a PE fund acquires their franchisor, not all funds do their homework and properly size up the franchise system's culture or competitive challenges before investing, and not all fund managers appreciate the difficulty of leading a collective of independent owners. But, on balance, PE funds offer system members opportunities they would otherwise never enjoy. They bring credibility to a franchise system by publicly expressing faith in the brand and capital to fund system expansion. While funds may be less tolerant of underperforming franchisees and focused on cost-savings, these measures help build brand value, attract sophisticated franchisee candidates and improve the resale market for franchise units.

No doubt, having a PE fund steward the brand adds a third dimension to the franchise paradigm: loyalty to fund investors. But professional fund managers are smart and, as they become more experienced operating franchise companies, they better appreciate the interdependence between their own and their franchisees' profitability. Funds today also invest heavily in multi-unit franchisees and understand franchising from both sides of the aisle.

What PE fund ownership may signal is that there is no longer room for “moms and pops” within the system's rank and file. System growth through “corporate” multi-unit franchisees may mean a seismic cultural shift for some franchise systems. PE funds that are insensitive to this cultural dynamic may be unprepared for managing the human element of franchising.

Franchisors Should Move Cautiously

Earsa R. Jackson, Strasburger & Price, LLP

The increasing presence of private equity funds in the franchise arena has its benefits as well as challenges. Private equity can be a godsend for a company ripe for expansion that does not have the capital to expand. Because private equity funds are so geared toward business and the bottom line, they can be useful in helping franchise systems trim down where necessary and cleaning up any loose ends on operations.

Depending on the degree to which the private equity fund involves itself in the operation of the core business, a franchise system may find that its corporate culture changes. I have heard franchise executives talk about difficulties with maintaining their own corporate identity once private equity comes to the table. Like every deal, the devil is in the details. Not all deals are created equal, just like not all private equity funds are created equal. A franchisor should take its time during the “courtship” phase to get to know the private fund before it jumps into bed with a stranger who might ultimately be calling the shots.

Positive Impact

Matthew Kreutzer, Armstrong Tea-sdale LLP

I think the influx of private money has affected franchising in a positive way. The private equity funds I have encountered have largely taken a “hands off” approach to management, being content to leave in place the leadership structure that has brought the franchisor to their attention. That said, the fund managers are not disinterested. Wanting to protect their investment, they closely monitor the franchisor. The franchisor's executives (many who owned their companies outright prior to the third-party investment) are faced with having to answer to a third party for their decisions, which generally results in increased efficiency and reduced expenses across the board. At the same time, these outside investors are important to the acquired franchisor, as they provide access to much-needed capital. The influx of money carries with it a number of benefits, allowing the franchisor to improve its infrastructure and to grow its system. As the system grows, franchisee businesses also tend to grow and improve with it.

Bottom-Line PerspectiveExtends to Litigation

Jeffrey Fillerup, McKenna Long & Aldridge, LLP

Private equity has generally had a favorable view of expected litigation/dispute resolution costs and problems in franchising, and this has made the investment in franchise businesses more attractive. From the perspective of potential investors, franchise businesses tend to have a favorable litigation track record, a positive franchisor-franchisee relationship history, and a relatively nominal amount of litigation and disputes relative to the revenues generated. On the downside, equity investors are not as enthusiastic about some of the litigation-related features of franchise businesses, such as franchisors' inability to have complete decision-making control over the entire system, which can sometimes lead to franchisor-franchisee conflicts.

When private equity has invested in a franchise businesses, on the franchisor or franchisee side, it has had a net positive impact on franchising. Private equity tends to have sophisticated and experienced management in all aspects of business, including litigation and dispute resolution, leading to common-practice litigation management. Litigation directed by private equity tends to be bottom-line driven, which is typical of litigation in other businesses, and there tends to be a broader perspective in connection with resolution of disputes and settlement of litigation. However, there are aspects of franchising that private equity has been less able to calculate in the dispute-resolution equation. Private equity [management] typically will not have experience with contentious franchisees and franchisee associations, whom they are forced to deal with because they cannot simply terminate problem groups or individuals as they can in other businesses. Private equity also has difficulty with some of franchising's unique issues, such as franchisees' exclusive territories, and finding a clear path to both overall system growth while avoiding franchisee encroachment complaints.