You Say You Want an Evolution? Private Equity Finds Its Franchising Groove

Roughly two years ago, a private equity firm retained this author to conduct the “franchising” part of the due diligence on a target company with more than 2,000 franchises. It was the private equity firm's first foray into franchising, and we conducted the due diligence in traditional fashion. We sent a detailed request list, formed a team to divvy up review of the responses, dove deep into the target company's past and present franchise documents and registration records, and closely examined a representative sample of the files of individual franchisees in the system. Then we wrote a detailed report to the private equity firm about our findings. The report included a background section on U.S. and Canadian franchise sales laws and franchise relationship laws and the consequences of noncompliance. We listed some concerns, mostly minor, about the target company's standard contracts and disclosure documents. Based on the sampling of franchisee files, we assessed the integrity of the company's disclosure and contracting processes ' getting the right things signed by the right people at the right time. We provided details about identifying “franchise sellers” and registering brokers.

Eighteen months later, the private equity firm retained us for a new transaction. The due diligence request to the target was not much different ' if you ask for the world upfront, you can always pare down the list by negotiation ' but the actual review was dramatically different. No real team was utilized for the project; it was just a principal reviewer with targeted help on discrete tasks. No full-blown report was issued upon completion of the review, either. Instead, we prepared a series of short memos and e-mails addressing specific issues for which the client requested analysis.

What was different after 18 months? True, the second transaction involved a smaller investment to acquire a minority interest in the franchise brand. The private equity firm, not surprisingly, started off by scaling back its anticipated due diligence budget to the size of the transaction. That proportionality fell aside, however, as the transaction proceeded.

Ultimately, it was not the size and nature of the transaction that most affected the franchise due diligence the second time around. What really changed in those 18 months was the private equity firm's knowledge about franchising, and the franchise law firm's knowledge about private equity. And judging from the Capital Roundtable programs a year apart, this education was by no means unique to one attorney-client
relationship.

Important Lessons

These are just a few of the important lessons that buyers, sellers and their professional advisers seem to have drawn in the last few years:

1) Don't get lost in the trees. When new to franchising, private equity firms tend to worry excessively about franchise law compliance (yes, you read that correctly). If they know anything about franchising, they know that franchise sales are highly regulated. Regulatory compliance (FDD disclosures and state filings) also happens to be the easiest subject for franchise counsel to review in due diligence. There are lots of paper records, and paralegals can do much of the work. You just find all of the state approval letters and line up the dates of the FDD receipts and contract signatures, right?

This combination of client concern and ease of review produces exactly what one would expect: a due diligence report weighted toward technical errors in franchise sales. But technical errors rarely threaten serious damage to the value of the transaction, unless they are so voluminous as to indicate a consistent disregard for compliance (which this author has yet to see). So the traditional due diligence effort in the registration/disclosure compliance area is usually disproportionate to the value of the information obtained. Fund managers have figured this out, and they have learned not to worry so much about a tainted franchise sale here and there. Meanwhile, franchise counsel have learned to temper their sample sizes and truncate the franchise compliance review if no serious problems are seen in the first wave.

2) Know your land mines. Private equity investors are interested in issues that can detract significantly from the value of the target company's operations ' enough to
affect the indemnities demanded from the seller, or perhaps even to affect the purchase price of the deal, or in an extreme case, to blow up the deal entirely. These may be business issues that are not within the province of franchise counsel, such as a flawed unit-level business model. Conversely, they may be legal issues about which franchise professionals are uniquely qualified.

Franchise counsel who have been sensitized to private equity thinking will focus on issues with potential widespread effect in the franchise system. These days, the longest, costliest and most disruptive legal battles typically spring from purchasing requirements and restrictions, management of advertising funds and territory battles (including parallel distribution channels). It can be difficult, however, to conduct due diligence on these concerns. When asked to identify an issue on which he would have wanted better due diligence by his fund, a 2011 Capital Roundtable panelist cited “the amount of ill will created by captive supply arrangements.” Active litigation or threats will make issues obvious, but otherwise the franchise due diligence team might have to dig below the surface (in advisory council or marketing committee minutes, for example).

Franchise advisers must continue to educate their private equity clients about new liability risks that might not have occurred to them yet. Based on recent experience, due diligence should consider, for example, whether the target franchise company could have exposure to “employer” liability for its franchisees or their staff, or liability for security breaches and disclosure of customers' personal data by franchisees. In one recent deal, we called for a close look at the franchisor's confidential operations manual because the table of contents hinted at a high degree of control over franchisees' employment practices.

3) Private equity companies are not vultures. The old stereotype of private equity funds looking to invest as little cash as possible, load up target companies with debt, strip out costs and flip the company for a profit at the first opportunity is no longer valid in franchising ' if it ever was. On the contrary, private equity companies have held their portfolio franchise concepts for extended periods, and not just because of the Great Recession. With striking speed, fund managers have learned what franchise professionals have always known ' that franchising is all about the relationships. For example, one panelist at the 2012 Capital Roundtable cited “the mentoring aspect of franchising” as one of the reasons that his company likes to invest in the sector. Another panelist recommended looking at the “age” of franchisees'i.e., how long they've been in the system ' as an indicator of the health of the franchise system.

Other 2012 participants specifically countered the idea of drastic, buyer-driven changes in the franchise system. One panelist observed that post-closing changes could easily “turn a healthy system into discontent,” while another pointed out that his fund was “not looking for businesses that we have to come in and change.” These comments had a different flavor from some of those made at the 2011 program, where, for example, a panelist named “convincing franchisees to invest in a re-brand” as an obstacle to growth of a portfolio company.

Of course, other forces may also be at work. Bloomberg Businessweek recently ran an article titled “Private Equity Shakeout” (February 25-March 3, 2013), which reported that there are now 4,500 buyout shops with $3 trillion in assets. According to the article, these firms have put to work only 28% of the “unprecedented” $702 billion that they raised from 2006 to 2008. Fund performance “has sagged,” and, in turn, the weaker performance hinders the ability to raise new capital for new funds, setting the stage for a “purge” of private equity players in coming years.

While the Businessweek article was by no means specific to the small-market and middle-market private equity companies that dominate activity in franchising, the article may help explain a less strictly financial approach toward target franchise companies and their franchisees. Simply put, the competition for deals is intense, so there is an incentive to appear less intimidating to potential sellers.

The more likely explanation of the emphasis on franchise relationships, however, is the intense education in franchising that private equity companies have received in the last several years. From buying, selling and managing franchise brands, PE firms have learned that returns on investment are a function of the overall health of the franchise system, which in turn depends on the quality of the franchise relationships. Through the same process, the PE firms have taught franchise system owners and their advisers how to enhance the value of their brands.

David W. Koch is a co-founding partner of Plave Koch PLC, a boutique franchise law firm in Reston, VA. He can be contacted at [email protected].

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Last fall, conference organizer The Capital Roundtable held its second full-day program on “Private Equity Investing in Franchise Companies” at the University Club in New York City. A roomful of small-market and middle-market private equity companies, investment bankers, lenders and brand executives gathered to explore the latest thinking on investing in franchise concepts. The event underscored private equity's current fascination with the franchising business model. But it also revealed that a mutual education process between private equity and franchising has been taking place.

Just one year earlier, a similar group with many of the same attendees had livened The Capital Roundtable's initial program on franchising. How did the discussion change from one year to the next, and how does it continue to evolve?

Inevitably, private equity professionals and franchising professionals ' fund managers, brand owners, operators, and their lawyers, accountants and consultants ' have influenced each other as they have worked together more often. The intensity of private equity transactions is, after all, a bonding experience. Professionals from different disciplines live in close mental quarters for weeks at a time, exposed to each other's talents and blind spots. Like a team of mountain climbers, they learn to trust and rely on each other ' except that the mountain is made of data, not rock.

Roughly two years ago, a private equity firm retained this author to conduct the “franchising” part of the due diligence on a target company with more than 2,000 franchises. It was the private equity firm's first foray into franchising, and we conducted the due diligence in traditional fashion. We sent a detailed request list, formed a team to divvy up review of the responses, dove deep into the target company's past and present franchise documents and registration records, and closely examined a representative sample of the files of individual franchisees in the system. Then we wrote a detailed report to the private equity firm about our findings. The report included a background section on U.S. and Canadian franchise sales laws and franchise relationship laws and the consequences of noncompliance. We listed some concerns, mostly minor, about the target company's standard contracts and disclosure documents. Based on the sampling of franchisee files, we assessed the integrity of the company's disclosure and contracting processes ' getting the right things signed by the right people at the right time. We provided details about identifying “franchise sellers” and registering brokers.

Eighteen months later, the private equity firm retained us for a new transaction. The due diligence request to the target was not much different ' if you ask for the world upfront, you can always pare down the list by negotiation ' but the actual review was dramatically different. No real team was utilized for the project; it was just a principal reviewer with targeted help on discrete tasks. No full-blown report was issued upon completion of the review, either. Instead, we prepared a series of short memos and e-mails addressing specific issues for which the client requested analysis.

What was different after 18 months? True, the second transaction involved a smaller investment to acquire a minority interest in the franchise brand. The private equity firm, not surprisingly, started off by scaling back its anticipated due diligence budget to the size of the transaction. That proportionality fell aside, however, as the transaction proceeded.

Ultimately, it was not the size and nature of the transaction that most affected the franchise due diligence the second time around. What really changed in those 18 months was the private equity firm's knowledge about franchising, and the franchise law firm's knowledge about private equity. And judging from the Capital Roundtable programs a year apart, this education was by no means unique to one attorney-client
relationship.

Important Lessons

These are just a few of the important lessons that buyers, sellers and their professional advisers seem to have drawn in the last few years:

1) Don't get lost in the trees. When new to franchising, private equity firms tend to worry excessively about franchise law compliance (yes, you read that correctly). If they know anything about franchising, they know that franchise sales are highly regulated. Regulatory compliance (FDD disclosures and state filings) also happens to be the easiest subject for franchise counsel to review in due diligence. There are lots of paper records, and paralegals can do much of the work. You just find all of the state approval letters and line up the dates of the FDD receipts and contract signatures, right?

This combination of client concern and ease of review produces exactly what one would expect: a due diligence report weighted toward technical errors in franchise sales. But technical errors rarely threaten serious damage to the value of the transaction, unless they are so voluminous as to indicate a consistent disregard for compliance (which this author has yet to see). So the traditional due diligence effort in the registration/disclosure compliance area is usually disproportionate to the value of the information obtained. Fund managers have figured this out, and they have learned not to worry so much about a tainted franchise sale here and there. Meanwhile, franchise counsel have learned to temper their sample sizes and truncate the franchise compliance review if no serious problems are seen in the first wave.

2) Know your land mines. Private equity investors are interested in issues that can detract significantly from the value of the target company's operations ' enough to
affect the indemnities demanded from the seller, or perhaps even to affect the purchase price of the deal, or in an extreme case, to blow up the deal entirely. These may be business issues that are not within the province of franchise counsel, such as a flawed unit-level business model. Conversely, they may be legal issues about which franchise professionals are uniquely qualified.

Franchise counsel who have been sensitized to private equity thinking will focus on issues with potential widespread effect in the franchise system. These days, the longest, costliest and most disruptive legal battles typically spring from purchasing requirements and restrictions, management of advertising funds and territory battles (including parallel distribution channels). It can be difficult, however, to conduct due diligence on these concerns. When asked to identify an issue on which he would have wanted better due diligence by his fund, a 2011 Capital Roundtable panelist cited “the amount of ill will created by captive supply arrangements.” Active litigation or threats will make issues obvious, but otherwise the franchise due diligence team might have to dig below the surface (in advisory council or marketing committee minutes, for example).

Franchise advisers must continue to educate their private equity clients about new liability risks that might not have occurred to them yet. Based on recent experience, due diligence should consider, for example, whether the target franchise company could have exposure to “employer” liability for its franchisees or their staff, or liability for security breaches and disclosure of customers' personal data by franchisees. In one recent deal, we called for a close look at the franchisor's confidential operations manual because the table of contents hinted at a high degree of control over franchisees' employment practices.

3) Private equity companies are not vultures. The old stereotype of private equity funds looking to invest as little cash as possible, load up target companies with debt, strip out costs and flip the company for a profit at the first opportunity is no longer valid in franchising ' if it ever was. On the contrary, private equity companies have held their portfolio franchise concepts for extended periods, and not just because of the Great Recession. With striking speed, fund managers have learned what franchise professionals have always known ' that franchising is all about the relationships. For example, one panelist at the 2012 Capital Roundtable cited “the mentoring aspect of franchising” as one of the reasons that his company likes to invest in the sector. Another panelist recommended looking at the “age” of franchisees'i.e., how long they've been in the system ' as an indicator of the health of the franchise system.

Other 2012 participants specifically countered the idea of drastic, buyer-driven changes in the franchise system. One panelist observed that post-closing changes could easily “turn a healthy system into discontent,” while another pointed out that his fund was “not looking for businesses that we have to come in and change.” These comments had a different flavor from some of those made at the 2011 program, where, for example, a panelist named “convincing franchisees to invest in a re-brand” as an obstacle to growth of a portfolio company.

Of course, other forces may also be at work. Bloomberg Businessweek recently ran an article titled “Private Equity Shakeout” (February 25-March 3, 2013), which reported that there are now 4,500 buyout shops with $3 trillion in assets. According to the article, these firms have put to work only 28% of the “unprecedented” $702 billion that they raised from 2006 to 2008. Fund performance “has sagged,” and, in turn, the weaker performance hinders the ability to raise new capital for new funds, setting the stage for a “purge” of private equity players in coming years.

While the Businessweek article was by no means specific to the small-market and middle-market private equity companies that dominate activity in franchising, the article may help explain a less strictly financial approach toward target franchise companies and their franchisees. Simply put, the competition for deals is intense, so there is an incentive to appear less intimidating to potential sellers.

The more likely explanation of the emphasis on franchise relationships, however, is the intense education in franchising that private equity companies have received in the last several years. From buying, selling and managing franchise brands, PE firms have learned that returns on investment are a function of the overall health of the franchise system, which in turn depends on the quality of the franchise relationships. Through the same process, the PE firms have taught franchise system owners and their advisers how to enhance the value of their brands.

David W. Koch is a co-founding partner of Plave Koch PLC, a boutique franchise law firm in Reston, VA. He can be contacted at [email protected].

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